<PAGE>

================================================================================

                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                               -----------------

                                   FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934.

    For the fiscal year ended December 31, 2001

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
    EXCHANGE ACT OF 1934.

                        Commission File Number: 0-22350

                               -----------------

                        MERCURY INTERACTIVE CORPORATION
            (Exact name of registrant as specified in its charter)

                      Delaware                     77-0224776
            (State or other jurisdiction        (I.R.S. Employer
          of incorporation or organization)    Identification No.)

                   1325 Borregas Avenue, Sunnyvale, CA 94089
                   (Address of principal executive offices)

                                (408) 822-5200
             (Registrant's telephone number, including area code)

          Securities registered pursuant to Section 12(g) of the Act:

                        Common Stock, $0.002 par value

   Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such a shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] NO [_]

   Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. [_]

   The aggregate market value of the voting stock held by non-affiliates of the
Registrant was approximately $2,827,743,482 as of February 28, 2002, based upon
the closing sale price reported for that date on the Nasdaq National Market.
Shares of Common Stock held by each officer and director and by each person who
owns 5% or more of the outstanding Common Stock have been excluded because such
persons may be deemed to be affiliates. This determination of affiliate status
is not necessarily conclusive for other purposes.

   The number of shares of Registrant's Common Stock outstanding as of February
28, 2002 was 83,463,503.

                      DOCUMENTS INCORPORATED BY REFERENCE

   Portions of the Proxy Statement for Registrant's 2002 Annual Meeting of
Stockholders to be held May 15, 2002 are incorporated by reference in Part III
of this Annual Report on Form 10-K.

================================================================================

<PAGE>

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                    Page
                                                                    ----
        <C>      <S>                                                <C>

                                      PART I
        Item 1.  Business..........................................   3
                 General...........................................   3
                 Enterprise Testing Solutions......................   4
                 Production Tuning Solution........................   6
                 Application Performance Management Solutions......   6
                 Research and Development..........................   7
                 Marketing, Sales and Support......................   8
                 Competition.......................................   9
                 Patents, Trademarks and Licenses..................   9
                 Personnel.........................................  10
        Item 2.  Properties........................................  11
        Item 3.  Legal Proceedings.................................  11
        Item 4.  Submission of Matters to a Vote of Security
                 Holders...........................................  11

                                      PART II

        Item 5.  Market for the Registrant's Common Equity and
                 Related Stockholder Matters.......................  12
        Item 6.  Selected Consolidated Financial Data..............  13
        Item 7.  Management's Discussion and Analysis of Financial
                 Condition and Results of Operations...............  14
        Item 7a. Quantitative and Qualitative Disclosures about
                 Market Risk.......................................  35
        Item 8.  Financial Statements and Supplementary Data.......  36
        Item 9.  Changes in and Disagreements with Accountants on
                 Accounting and Financial Disclosure...............  36

                                     PART III

        Item 10. Directors and Executive Officers of the Registrant  37
        Item 11. Executive Compensation............................  37
        Item 12. Security Ownership of Certain Beneficial Owners
                 and Management....................................  37
        Item 13. Certain Relationships and Related Transactions....  37

                                      PART IV

        Item 14. Exhibits, Financial Statement Schedules and
                 Reports on Form 8-K...............................  38
</TABLE>


                                      2

<PAGE>

   This Annual Report on Form 10-K contains forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934 and Section
27A of the Securities Act of 1933. In some cases, forward-looking statements
are identified by words such as "believes," "anticipates," "expects,"
"intends," "plans," "will," "may" and similar expressions. In addition, any
statements that refer to our plans, expectations, strategies or other
characterizations of future events or circumstances are forward-looking
statements. Our actual results could differ materially from those discussed in,
or implied by, these forward-looking statements. Factors that could cause
actual results or conditions to differ from those anticipated by these and
other forward-looking statements include those more fully described in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations-Risk Factors." Our business may have changed since the date hereof,
and we undertake no obligation to update the forward-looking statements in this
Annual Report on Form 10-K.

                                    PART I

Item 1.  Business

General

   We are the leading provider of enterprise testing, production tuning and
performance management solutions that help companies keep their digital
business processes operating at peak performance and closely aligned with their
business goals. Our products and services help customers identify and assess
performance problems, maximize overall performance with minimum investment and
manage ongoing application availability, performance and service levels. We
offer our testing and application performance management (APM) solutions as
both software and managed services. The managed services versions of our
offerings provide access to our global infrastructure, monitoring capabilities
as well as the extensive experience we have acquired from thousands of tuning
sessions already performed.

   Our customers represent a wide range of industries including global
enterprises such as Barclays Bank, BMW, British Airways, Knight Ridder,
Lufthansa, Merck, Target, Standard & Poor's and USA Today. We also maintain
strong alliances with major systems integrators, including Accenture, Deloitte
Consulting, IBM Global Services, PricewaterhouseCoopers LLP and others on a
worldwide basis and we work with a wide variety of speciality consulting
partners.

   Our portfolio of solutions address the key problems IT organizations face
today in aligning critical business processes, including functionality,
availability, scalability, performance and service level management with the IT
infrastructure. Using our industry-leading automated testing solutions,
customers can efficiently test their business applications prior to deployment,
through a repeatable approach, to ensure they work as anticipated before
releasing to internal or external users. Using our production tuning offering,
customers can optimize performance of their infrastructure, applications and
security components and manage their IT investments in a cost effective manner.
Using our APM solutions, customers can manage the availability and performance
of their production environments from the end-user perspective. These offerings
can quickly detect, diagnose and isolate performance problems experienced by
users and can correlate this information to system metrics. Our solutions are
integrated allowing customers to leverage their technical and personnel
investments among our offerings. Our solutions also support today's most common
enterprise environments and technologies and are available on a wide range of
platforms. Our solutions include:

  .  Load testing products that stress applications under real-world conditions
     to predict systems' behavior, scalability and performance and to identify
     and isolate problems;

  .  Functional testing products that help ensure applications operate as
     expected;

  .  Test process management products that organize and manage the testing
     process to determine application readiness;

                                      3

<PAGE>

  .  Managed load testing services that identify bottlenecks and capacity
     constraints before a Web site or Web-enabled application goes live;

  .  Production tuning services that utilize our extensive experience,
     industry-standard tools, and proven procedures to systematically tune each
     tier and component of the production system to maximize utilization of the
     system and improve performance;

  .  Application performance management applications and platforms that provide
     the ability to manage production applications and infrastructures from a
     user or transactional point of view;

  .  Web performance monitoring products that monitor the use of business
     applications and related business processes in real time and alert
     operations groups to performance problems before users experience them; and

  .  Managed Web performance monitoring services that monitor business
     applications and related business processes using our monitoring
     capabilities across the globe.

   To ensure that our solutions can support the entire infrastructure, we
collaborate with the major enterprise software and Internet infrastructure
companies, including Akamai, BEA Systems, Check Point, Cisco, Citrix Systems,
Hewlett-Packard, IBM, Microsoft, Oracle, PeopleSoft, SAP, Siebel Systems and
Sun Microsystems. Not only do these alliances ensure that our solutions are
optimized for use with their product offerings, many of these collaborations
allow us to conduct joint marketing programs and joint seminars and participate
in their user conferences.

   In May 2001, we acquired Freshwater Software, Inc., a leader in providing
easy-to-use and easily deployable APM tools. With that addition, we gained a
significant customer base, downloadable software tools, and a strong team.
Since the acquisition, we have seen an increase in the overall adoption of our
APM solutions.

Enterprise Testing Solutions

   Our enterprise testing solutions include:

  ActiveTest

   ActiveTest(TM) is a hosted load testing service that can conduct full-scale
testing of Web sites and Web-enabled applications in as little as 24 hours.
Based on LoadRunner technology, ActiveTest can emulate the behavior of millions
of users interacting with an application to reveal bottlenecks and capacity
constraints before the site goes live. This managed service enables customers
with minimal hardware, personnel or technical expertise to achieve rapid
results. ActiveTest was initially released in 2000.

  ActiveTest SecureCheck

   ActiveTest SecureCheck(TM) is a managed service that tests the security of
Web applications and infrastructures. Using a variety of testing techniques,
ActiveTest SecureCheck stresses key security infrastructure components to
identify system vulnerabilities and gauge the impact on users. ActiveTest
SecureCheck was initially released in 2001.

  Astra FastTrack

   Astra FastTrack(TM) is a fast, simple Web-based defect-tracking tool. It
supports the process for end-to-end defect management, helping companies
deliver higher quality applications. Astra FastTrack was initially released in
2001.

                                      4

<PAGE>

  Astra LoadTest

   Astra(R) LoadTest is an easy-to-use load testing tool that tests the
scalability and performance of Web applications. With Astra LoadTest, users can
emulate the traffic of thousands of real users to identify and isolate
bottlenecks and optimize the user experience. Astra LoadTest was initially
released in 1996.

  Astra QuickTest

   Astra QuickTest(TM) is an icon-based tool that allows expert and novice
testers to test the functionality of dynamically changing Web applications. By
mirroring end-user behavior, Astra QuickTest creates interactive customizable
tests that simplify and shorten the testing cycle for complex Web environments.
Astra QuickTest was initially released in 1998.

  Astra SiteManager

   Astra SiteManager(R) is a comprehensive visual Web site management tool that
is designed to meet the challenges faced by Webmasters, Internet professionals
and business managers of rapidly growing Web sites. Astra SiteManager
automatically schedules and performs scans of an entire Web site--highlighting
functional areas with color-coded links and URLs--to create a complete visual
map of a Web site. Astra SiteManager was initially released in 1996.

  LoadRunner

   LoadRunner(R) is a load testing tool that predicts system behavior and
performance. It exercises an entire enterprise infrastructure by emulating
thousands of users and the transactions performed by them to identify and
isolate problems. LoadRunner's integrated real-time monitors enable
organizations to minimize test cycles, optimize performance and accelerate
application deployment. LoadRunner is available on a wide range of platforms,
including Windows NT, Windows 2000, Windows XP, Sun Solaris, HP-UX, IBM AIX and
Linux. LoadRunner was initially released in 1993.

  LoadRunner TestCenter

   LoadRunner TestCenter(TM) is a global load testing tool that enables
organizations to manage multiple, concurrent load testing projects across
geographic locations. It controls all aspects of large-scale load testing
projects, including resource allocation and scheduling, from a centralized
location accessible via the Web. LoadRunner TestCenter was initially released
in 2001.

  QuickTest Professional

   QuickTest(TM) Professional is an icon-based tool that automates the
functional and regression testing of dynamically changing Web applications. Its
ActiveScreen technology offers the shortest learning curve in the industry
while allowing users to create reusable, easy-to-maintain, comprehensive tests
for browser-based and Java-based applications and ERP/CRM solutions. QuickTest
Professional was initially released in 2001.

  TestDirector

   TestDirector(R) is a Web-based test management solution that globally
coordinates testing across an organization. TestDirector integrates
requirements management with test planning, test scheduling, test execution and
defect tracking in a single application to accelerate the testing process.
TestDirector was initially released in 1994.

                                      5

<PAGE>

  WinRunner

   WinRunner(R) is an enterprise functional testing tool that verifies that
applications work as expected. By capturing, verifying and replaying user
interactions automatically, WinRunner identifies defects and ensures that
business processes work flawlessly and remain reliable throughout the
lifecycle. WinRunner is available for Windows 2000, Windows Me and Windows NT
platforms. WinRunner was initially released in 1993.

  XRunner

   XRunner(R) automates functional testing to ensure X-Window-based
applications work as expected. It records business processes into test scripts,
supports script enhancements as the application is developed or updated,
executes scripts, reports results and enables script reusability throughout an
application's lifecycle. XRunner was initially released in 1991.

Production Tuning Solution

   Our initial production tuning solution is described below:

  ActiveTune

   ActiveTune(TM) utilizes our extensive experience as well as
industry-standard tools and proven processes to systematically tune each tier
and component of the production system to maximize utilization of the system
and improve performance. As a combination of hosted and on-site services,
ActiveTune brings together our extensive experience to optimize the
infrastructure necessary to support business objectives. ActiveTune was
initially released in 2002.

Application Performance Management Solutions

   Our application performance management solutions include:

  ActiveWatch

   ActiveWatch(TM) is a managed service that monitors business application
performance around the clock to proactively identify and pinpoint performance
problems with critical business processes and related transactions. Based on
Topaz, ActiveWatch leverages our infrastructure and monitoring capabilities
deployed across the globe to ensure peak performance 24 hours a day.
ActiveWatch was initially released in 1999.

  Topaz

   Topaz(TM) is a performance management solution for IT organizations. Topaz
manages availability, performance and service levels of applications and
business processes from an end user perspective to ensure the best on-line
experience for customers and users. By using Topaz, IT organizations can obtain
critical information needed to make better business decisions and more
efficiently utilize IT resources. Topaz enables customers to:

  .  Measure end user experience around the clock and generate real-time alerts
     for early warnings of performance issues;

  .  Correlate performance issues affecting user experience to root cause in
     the enterprise and web infrastructure both inside and outside the firewall
     and within applications to accelerate problem resolution; and

  .  Manage service levels with performance metrics that enable the
     establishment and enforcement of service level agreements defined around
     business goals.

                                      6

<PAGE>

   Topaz is a modular, scalable solution that gives IT organizations the
flexibility to tailor it to their organization's business needs by addressing
APM at three key levels:

  .  Data collection: Topaz collects performance data from inside and outside
     the firewall and throughout the infrastructure.

  .  Data management: Monitoring data from throughout the infrastructure is
     collected into a centralized repository.

  .  Data reporting: Performance information is organized in the form of graphs
     and reports that provide a view from the business perspective.

   Topaz was initially released in 1999.

  SiteScope

   SiteScope(R) is a rapidly deployable solution for operational monitoring of
networked business systems inside the firewall. Customers can choose from over
50 standard monitor types to test the availability and operation of their key
networked systems. SiteScope was acquired in May 2001 in conjunction with our
acquisition of Freshwater Software, Inc.

  SiteSeer

   SiteSeer(R) is a self-service, hosted operational monitoring service for
testing system availability from outside the firewall. With monitoring
locations on major Internet backbones, SiteSeer allows enterprises to check
that their Web sites are open for business 24x7. SiteSeer was acquired in May
2001 in conjunction with our acquisition of Freshwater Software, Inc.

  Global SiteReliance

   Global SiteReliance(TM) allows service providers to use real-time operations
monitoring technology from Freshwater Software and Mercury Interactive to
deliver Web-based systems monitoring and problem remediation solutions to their
customers. Global SiteReliance was acquired in May 2001 in conjunction with our
acquisition of Freshwater Software, Inc.

Research and Development

   Since our inception in 1989, we have made substantial investments in
research and product development. We believe that our success will depend in
large part on our ability to maintain and enhance our current product line,
develop new products, maintain technological competitiveness, and meet changing
customer requirements.

   In addition to the teams developing testing and performance monitoring
products and services, we maintain an advanced research group that is
responsible for exploring new directions and applications of core technologies,
migrating new technologies into the existing product lines and maintaining
research relationships outside Mercury Interactive both within industry and
academia. The research and development group also maintains relationships with
third-party software vendors and with all major hardware vendors on whose
platforms our products operate. Key development engineers are rotated to
assignments in customer support positions in our major markets for periods
ranging from three months to two years. This improves feedback from current
customers and strengthens ties between the customer support organization and
the research and development group.

   Our primary research and development group is located near Tel Aviv, Israel.
Performing research and development in Israel offers a number of strategic
advantages. Our Israeli engineers typically hold advanced degrees in
computer-related disciplines. Operation in Israel has allowed us to enjoy tax
incentives from the

                                      7

<PAGE>

government of Israel. Geographic proximity to Europe, a strategic market for
Mercury Interactive, offers another key advantage.

   We also have research and development capabilities in Boulder, Colorado that
were acquired in conjunction with our acquisition of Freshwater Software, Inc.
in May 2001.

   As of December 31, 2001, our worldwide research and development group
consisted of 350 employees. Our research and development expenses were $37.2
million in 2001, $32.0 million in 2000 and $23.5 million in 1999. We anticipate
that we will continue to commit substantial resources to research and
development.

Marketing, Sales and Support

   We distribute our products and offer our services both directly, through our
sales force, and indirectly, through our relationships with systems integrators
and value-added resellers.

  Direct Sales

   We sell our products primarily through our direct sales organization. We
also employ highly skilled field application engineers who, together with our
sales force, are capable of serving the sophisticated needs of prospective
customers. Our direct sales organization also includes our cybersales group. As
of December 31, 2001, our direct sales organization consisted of 650 employees.

   We have 24 sales and support offices throughout the US. Internationally, our
subsidiaries and branches operate 32 sales and support offices located in Asia,
Australia, Canada, Brazil, Europe, and Israel. We also market our products
through international distributors in some markets.

   International sales represented 35% of our total revenues in 2001, 32% in
2000, and 34% in 1999. We expect that in future periods, international sales
will continue to account for a significant portion of our total revenue.

  Indirect Distribution Channels

   We derive a substantial portion of our revenue from sales of our products
through an indirect distribution network of value-added resellers. In addition,
we maintain strong reseller arrangements with the large systems integration
firms, including Accenture, Deloitte Consulting, IBM Global Services,
PricewaterhouseCoopers LLP, and others.

  Technical Support

   We believe that strong technical support is crucial to both the initial
marketing of our products and maintenance of customer satisfaction, which in
turn enhances our reputation and generates repeat orders. In addition, we
believe that the customer interaction and feedback involved in our ongoing
support functions provide us with information on market trends and customer
requirements that is critical to future product development efforts.

   Pre-sales support is provided by sales personnel and post-sales support is
provided by our customer support and professional services organizations
through training and consulting engagements and renewable annual maintenance
contracts. As of December 31, 2001, our support organizations consisted of 246
employees. Our maintenance contracts provide for technical and emergency
support as well as software upgrades, on an "if and when available" basis. When
our local sales and support offices are unable to solve a problem, our
engineers and product developers in Israel work with the support personnel. By
taking advantage of time differences, we can provide support around the clock,
ensuring prompt resolution of problems.

                                      8

<PAGE>

  Pricing

   We license our software to customers under non-exclusive license agreements
that generally restrict use of the products to internal purposes at a specified
site. We typically license software products to either allow up to a set number
of users to access the software on a network at any one time, using any
workstation attached to that network, or to allow use of the software on
designated computers or workstations. In addition, our managed services, our
APM products and some of our testing products are priced based on usage, such
as the number of transactions monitored, number of virtual users emulated per
day, or period of usage.

   Our products are priced to encourage customers to purchase multiple products
and licenses because our cost to support a one-user configuration is almost the
same as a multiple-user configuration. License fees depend on the product
licensed, the number of users of the product licensed and the country in which
such licenses are sold, as international prices tend to be higher than US
prices. Sales to our indirect sales channels, which are intended for resale to
end users, are made at discounts off of our list prices, based on the sales
volume of the indirect sales channels. Original purchases of maintenance and
renewal maintenance sales are priced at specified percentages of the related
license fees. Training and consulting revenues are generated on a time and
expense basis.

Competition

   The market for enterprise testing, tuning, and performance monitoring
products and services is extremely competitive, dynamic, and subject to
frequent technological change. There are few substantial barriers of entry in
our market. In addition, the use of the Internet for a growing range of
applications is a recent and emerging phenomenon. The Internet has further
reduced these barriers of entry, allowing other companies to compete with us in
the testing and application performance management markets. As a result of the
increased competition, our success will depend, in large part, on our ability
to identify and respond to the needs of potential customers, and to new
technological and market opportunities, before our competitors identify and
respond to these needs and opportunities. We may fail to respond quickly enough
to these needs and opportunities.

   In the market for enterprise testing solutions, our principal competitors
include Compuware, Empirix, Radview, Rational Software, and Segue Software. In
the new and rapidly changing market for application performance management
solutions, our principal competitors include providers of hosted services such
as Gomez and Keynote Systems, established providers of systems and network
management software such as BMC Software, Computer Associates, HP OpenView and
Tivoli, a division of IBM, and emerging companies. Additionally, we face
potential competition in this market from existing providers of testing
solutions such as Segue Software and Compuware.

   We believe that the principal competitive factors affecting our market are:

  .  product functionality;

  .  product performance, including scalability and reliability;

  .  price and cost-effectiveness;

  .  quality of support and service; and

  .  company reputation.

   Although we believe that our products currently compete favorably with
respect to these factors, the market for application performance management and
tuning are new and rapidly evolving. We may not be able to maintain our
competitive position, and competitive pressure could seriously harm our
business.

Patents, Trademarks and Licenses

   We rely on a combination of patents, copyrights, trademarks, service marks,
and trade secret laws and contractual restrictions to establish and protect
proprietary rights in our products and services. The source code

                                      9

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for our products is protected both as a trade secret and as an unpublished
copyrighted work. Despite our precautions, it may be possible for a third party
to copy or otherwise obtain and use our products or technology without
authorization. In addition, the laws of various countries in which our products
may be sold may not protect our products and intellectual property rights to
the same extent as the laws of the US. Our competitors may independently
develop technologies that are substantially equivalent or superior to our
technology.

   We rely on software that we license from third parties for certain
components of our products. In the future, we may license other third party
technologies to enhance our products and meet evolving customer needs. The
failure to license any necessary technology, or to maintain our existing
licenses, could result in reduced demand for our products.

   Because the software industry is characterized by rapid technological
change, we believe that factors such as the technological and creative skills
of our personnel, new product developments, frequent product enhancements, name
recognition and reliable product maintenance are more important to establishing
and maintaining a technology leadership position than the various legal
protections of our technology.

   We hold 11 patents for elements contained in some of our products, and we
have filed several other US and foreign patent applications on various elements
of our products. Our patent applications may not result in issued patents and,
if issued, such patents may not be upheld if challenged.

   Although we believe that our products and other proprietary rights do not
infringe upon the proprietary rights of third parties, third parties may assert
intellectual property infringement claims against us in the future. Any such
claims may result in costly, time-consuming litigation and may require us to
enter into royalty or cross-license arrangements.

Personnel

   As of December 31, 2001, we had a total of 1,597 employees, of which 703
were based in the Americas and 894 were based internationally. Of the total,
1,031 were engaged in marketing, sales and related customer support services,
350 were in research and development, and 216 were in general, administrative
and information technology and operations support functions. In May 2001, we
acquired Freshwater Software, Inc., including its employees. In July 2001, we
had a reduction in workforce of 8% worldwide. Our success depends in
significant part upon the performance of our senior management and certain key
employees. Competition for highly skilled employees, including sales, technical
and management personnel, is intense in the software and technology industry.
We may not be able to recruit and retain key sales, technical and managerial
employees. Our failure to attract, assimilate or retain highly qualified sales,
technical and managerial personnel could seriously harm our business. None of
our employees is represented by a labor union, and we have never experienced
any work stoppages and we believe that our employee relations are in good
standing.

   Our executive officers as of February 28, 2002 are as follows:

<TABLE>
<CAPTION>
    Name                Age                     Position
    ----                ---                     --------
<S>                     <C> <C>
Amnon Landan........... 43  President, Chief Executive Officer and Chairman of the Board of Directors
Kenneth Klein.......... 42  Chief Operating Officer and Director
Douglas Smith.......... 50  Executive Vice President and Chief Financial Officer
Moshe Egert............ 37  President of European Operations
</TABLE>

   Mr. Amnon Landan has served as our President and Chief Executive Officer
since February 1997, has served as Chairman of the board of directors since
July 1999, and has been a director since February 1996. From October 1995 to
January 1997, he served as President, and from March 1995 to September 1995, he
served as President of North American Operations. He served as Chief Operating
Officer from August 1993 until March 1995. From December 1992 to August 1993,
he served as our Vice President of Operations and from June 1991

                                      10

<PAGE>

to December 1992, he served as Vice President of Research and Development. From
November 1989 to June 1991, he served with us in various technical positions.

   Mr. Kenneth Klein has served as our Chief Operating Officer since January
2000 and a member of the board of directors since July 2000. He served as
President of North American Operations from July 1998 until December 1999. From
April 1995 to July 1998, he served as Vice President of North American Sales.
From May 1992 to March 1995, he served as our Western Area Sales Manager. From
March 1990 to May 1992, he served as Regional Sales Manager for Interactive
Development Environments, a CASE tool company. He has served as a director of
Tumbleweed Communications Corporation since February 2000.

   Mr. Douglas Smith has served as our Executive Vice President and Chief
Financial Officer since November 2001. Prior to that he served as our Executive
Vice President of Corporate Development from May 2000 until November 2001. From
September 1996 to May 2000, he served in various positions with Chase H&Q, most
recently as Managing Director and co-head of the Internet Group. From September
1994 to September 1996, he was the Chief Financial Officer and Executive Vice
President of Strategy for ComputerVision Corporation.

   Mr. Moshe Egert has served as our President of European Operations since
July 1999. From July 1996 to June 1999, he served as our Vice President of
European Operations. From February 1994 to June 1996, he served as our Director
of European Marketing. From October 1990 through January 1994, he served with
us in several management and technical positions.

Item 2.  Properties

   We are headquartered in Sunnyvale, California in two buildings that we own
with a total square footage of 105,500. At the end of 2000, we purchased 26,000
and 24,000 square foot buildings in Sunnyvale, which will serve in the future
as additional headquarters, sales, and operations facilities.

   Our research and development activities are conducted by our subsidiary in
Israel in a 132,000 square foot building that we own. At the end of 2001, we
substantially completed the construction of an additional 123,000 square foot
building, which will serve as an additional research and development facility
in the future.

   Our field sales and support operations occupy leased facilities in 23
locations in the US, one location in Canada, one location in Brazil, 19
locations in Europe, two locations in South Africa, two locations in Australia
and six locations in Asia.

   We believe that our existing facilities are adequate for our current needs.

Item 3.  Legal Proceedings

   There are presently no material legal proceedings pending, other than
routine litigation incidental to our business, to which we are a party or to
which any of our properties is subject.

Item 4.  Submission of Matters to a Vote of Security Holders

   No matters were submitted during the fourth quarter of 2001 to a vote of the
holders of our common stock through the solicitation of proxies or otherwise.

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                                    PART II

Item 5.  Market for the Registrant's Common Equity and Related Stockholder
Matters

Market for Common Stock

   Our common stock is traded publicly on the Nasdaq National Market under the
trading symbol "MERQ." The following table presents, for the periods indicated,
the high and low sales prices of our common stock as reported on the Nasdaq
National Market.

<TABLE>
<CAPTION>
                                                 High    Low
                                                ------- ------
                  <S>                           <C>     <C>
                  Year Ended December 31, 2000:
                     First Quarter............. $134.50 $40.13
                     Second Quarter............  110.38  45.00
                     Third Quarter.............  159.75  81.63
                     Fourth Quarter............  162.50  57.88
                  Year Ended December 31, 2001:
                     First Quarter............. $100.44 $35.00
                     Second Quarter............   75.50  30.75
                     Third Quarter.............   63.47  18.00
                     Fourth Quarter............   36.93  18.16
</TABLE>

   The prices shown in the table above reflect the two-for-one split of our
common stock, which was distributed as a stock dividend to our stockholders on
February 11, 2000.

Holders of Record

   On February 28, 2002, there were approximately 40,000 holders of record of
our common stock. Because many of these shares are held by brokers and other
institutions on behalf of stockholders, we are unable to estimate the total
number of stockholders represented by these record holders.

Dividends

   We have never declared or paid any cash dividends on our common stock. We
currently intend to retain earnings for use in our business and do not
anticipate paying any cash dividends in the foreseeable future.

                                      12

<PAGE>

Item 6.  Selected Consolidated Financial Data

<TABLE>
<CAPTION>
                                                                                     Year ended December 31,
                                                                           --------------------------------------------
                                                                             2001     2000     1999     1998     1997
                                                                           -------- -------- -------- -------- --------
                                                                             (in thousands, except per share amounts)
<S>                                                                        <C>      <C>      <C>      <C>      <C>
Consolidated Statements of Operations Data:
Revenue:
   License................................................................ $236,600 $216,100 $130,900 $ 84,450 $ 56,683
   Service................................................................  124,400   90,900   56,800   36,550   20,017
                                                                           -------- -------- -------- -------- --------
      Total revenue.......................................................  361,000  307,000  187,700  121,000   76,700
                                                                           -------- -------- -------- -------- --------
Cost of revenue:
   License................................................................   24,158   17,138    7,736    6,291    4,351
   Service................................................................   29,231   24,679   16,957   10,500    5,849
                                                                           -------- -------- -------- -------- --------
      Total cost of revenue...............................................   53,389   41,817   24,693   16,791   10,200
                                                                           -------- -------- -------- -------- --------
Gross profit..............................................................  307,611  265,183  163,007  104,209   66,500
                                                                           -------- -------- -------- -------- --------
Operating expenses:
   Research and development...............................................   37,162   32,042   23,484   16,907   11,333
   Marketing and selling..................................................  189,600  151,897   89,874   58,186   37,355
   General and administrative.............................................   23,086   17,831   11,662    8,780    6,736
   Amortization of unearned stock-based compensation......................    1,999       --       --       --       --
   Restructuring, integration and other related charges...................    5,361       --    2,000       --       --
   Amortization of goodwill and other intangible assets...................   30,125       --       --       --       --
   Write off of in-process research and development and related expenses..       --       --       --       --    5,500
                                                                           -------- -------- -------- -------- --------
      Total operating expenses............................................  287,333  201,770  127,020   83,873   60,924
                                                                           -------- -------- -------- -------- --------
Income from operations....................................................   20,278   63,413   35,987   20,336    5,576
Other income, net.........................................................   10,068   17,462    6,026    4,640    3,083
                                                                           -------- -------- -------- -------- --------
Income before provision for income taxes..................................   30,346   80,875   42,013   24,976    8,659
Provision for income taxes................................................   12,504   16,175    8,869    5,451    2,927
                                                                           -------- -------- -------- -------- --------
Net income before extraordinary item......................................   17,842   64,700   33,144   19,525    5,732
Extraordinary item--gain on early retirement of debt, net of taxes........   16,312       --       --       --       --
                                                                           -------- -------- -------- -------- --------
Net income................................................................ $ 34,154 $ 64,700 $ 33,144 $ 19,525 $  5,732
                                                                           ======== ======== ======== ======== ========
Basic net income per share:
   Net income before extraordinary item................................... $   0.21 $   0.81 $   0.44 $   0.28 $   0.09
   Extraordinary item--gain on early retirement of debt, net of taxes.....     0.20       --       --       --       --
                                                                           -------- -------- -------- -------- --------
   Net income............................................................. $   0.41 $   0.81 $   0.44 $   0.28 $   0.09
                                                                           ======== ======== ======== ======== ========
Diluted net income per share:
   Net income before extraordinary item................................... $   0.20 $   0.70 $   0.39 $   0.25 $   0.08
   Extraordinary item--gain on early retirement of debt, net of taxes.....     0.18       --       --       --       --
                                                                           -------- -------- -------- -------- --------
   Net income............................................................. $   0.38 $   0.70 $   0.39 $   0.25 $   0.08
                                                                           ======== ======== ======== ======== ========
Weighted average common shares (basic)....................................   82,559   79,927   76,112   70,654   65,494
                                                                           ======== ======== ======== ======== ========
Weighted average common shares and equivalents (diluted)..................   89,725   91,938   85,208   78,818   68,458
                                                                           ======== ======== ======== ======== ========

                                                                                           December 31,
                                                                           --------------------------------------------
                                                                             2001     2000     1999     1998     1997
                                                                           -------- -------- -------- -------- --------
Consolidated Balance Sheet Data:
Cash, cash equivalents and short-term investments......................... $427,781 $628,743 $171,327 $109,203 $ 88,568
Working capital (current assets less current liabilities)................. $329,455 $552,938 $137,066 $ 97,288 $ 87,733
Total assets.............................................................. $927,625 $976,375 $297,218 $204,686 $143,663
Stockholders' equity...................................................... $354,345 $303,032 $199,531 $146,408 $112,120
</TABLE>

                                      13

<PAGE>

Item 7.  Management's Discussion and Analysis of Financial Condition and
Results of Operations

   The following discussion contains forward-looking statements within the
meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A
of the Securities Act of 1933. In some cases, forward-looking statements are
identified by words such as "believes," "anticipates," "expects," "intends,"
"plans," "will," "may" and similar expressions. In addition, any statements
that refer to our plans, expectations, strategies or other characterizations of
future events or circumstances are forward-looking statements. Our actual
results could differ materially from those discussed in, or implied by, these
forward-looking statements. Factors that could cause actual results or
conditions to differ from those anticipated by these and other forward-looking
statements include those more fully described in "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Risk Factors." Our
business may have changed since the date hereof, and we undertake no obligation
to update these forward-looking statements.

Overview

   We were incorporated in 1989 and began shipping testing products in 1991.
Since 1991, we have introduced a variety of solutions for enterprise testing,
production tuning and application performance management which are focused on
helping our customers deploy better quality applications and to ensure their
performance and availability post-deployment. We also provide both professional
services to help customers implement our solutions as well as managed services
for customers who do not want or have the internal resources to implement our
solutions.

   In May 2001, we acquired all of the outstanding securities of Freshwater
Software, Inc, a provider of eBusiness monitoring and management solutions. The
transaction was accounted for as a purchase and, accordingly, the operating
results of Freshwater have been included in our accompanying consolidated
financial statements from the date of acquisition. If the purchase had occurred
at the beginning of each period, our consolidated net revenues would have been
$367.3 million in 2001, $315.8 million in 2000 and $191.5 million in 1999; net
income (loss) would have been $4.4 million in 2001, $21.6 million in 2000 and
$(26.9) million in 1999; and earnings (loss) per share would have been $0.05 in
2001, $0.24 in 2000 and $(0.32) in 1999.

                                      14

<PAGE>

Results of Operations

   The following table sets forth, as a percentage of total revenue, certain
consolidated statements of operations data for the periods indicated. These
operating results are not necessarily indicative of the results for any future
period.

<TABLE>
<CAPTION>
                                                                    Years ended
                                                                    December 31,
                                                                   -------------
                                                                   2001 2000 1999
                                                                   ---- ---- ----
<S>                                                                <C>  <C>  <C>
Revenue:
   License........................................................  66%  70%  70%
   Service........................................................  34   30   30
                                                                   ---  ---  ---
       Total revenue.............................................. 100  100  100
                                                                   ---  ---  ---
Cost of revenue:
   License........................................................   7    6    4
   Service........................................................   8    8    9
                                                                   ---  ---  ---
       Total cost of revenue......................................  15   14   13
                                                                   ---  ---  ---
Gross profit......................................................  85   86   87
                                                                   ---  ---  ---
Operating expenses:
   Research and development.......................................  10   10   13
   Marketing and selling..........................................  53   49   48
   General and administrative.....................................   6    6    6
   Amortization of unearned stock-based compensation..............   1   --   --
   Restructuring, integration and other related charges...........   1   --    1
   Amortization of goodwill and other intangible assets...........   8   --   --
                                                                   ---  ---  ---
       Total operating expenses...................................  79   65   68
                                                                   ---  ---  ---
Income from operations............................................   6   21   19
Other income, net.................................................   3    5    3
                                                                   ---  ---  ---
Income before provision for income taxes..........................   9   26   22
                                                                   ---  ---  ---
Provision for income taxes........................................   4    5    5
                                                                   ---  ---  ---
Net income before extraordinary item..............................   5   21   17
Extraordinary item--gain on early retirement of debt, net of taxes   5   --   --
                                                                   ---  ---  ---
Net income........................................................   0%  21%  17%
                                                                   ===  ===  ===
</TABLE>

  Revenue

   License revenue, which is comprised of license fees from our products and
managed services, increased to $236.6 million in 2001 from $216.1 million in
2000. Our growth in license revenue was primarily attributable to growth in
subscription revenue from our new application performance management (APM)
offerings, which increased to $27.4 million in 2001 from $4.0 million in 2000.
License revenue from testing products declined to $209.2 million in 2001 from
$212.0 million in 2000, primarily due to the lower testing revenue in the
second half of 2001 because of the economic downturn in North America and
reduced spending by IT organizations. We may experience little to no growth in
overall license revenue in the near-term. We expect sales of our APM products
to grow and expect sales of our testing products to grow at a slower rate. Our
testing products are generally sold under perpetual licenses with the majority
of the revenue recognizable in the period of the initial sale. Our APM products
and managed services are generally sold under subscription arrangements with
lower up-front revenue, and recurring and renewable future revenue.

                                      15

<PAGE>

   License revenue increased to $216.1 million in 2000 from $130.9 million in
1999. In 2000, our growth in license revenue was attributable primarily to
growth in license fees from our testing products of $81.2 million, as well as
revenue from our new APM products of $4.0 million.

   Service revenue, which is comprised of maintenance, training and consulting,
increased to $124.4 million in 2001 from $90.9 million in 2000. The increase in
service revenue in 2001 compared to 2000 was primarily the result of renewals
of existing maintenance contracts. We expect that service revenue will continue
to increase in absolute dollars as long as our customer base continues to grow.

   Service revenue increased to $90.9 million in 2000 from $56.8 million in
1999. In 2000, the increase in service revenue was a result of new maintenance
contracts accompanying the growth in license revenue as well as renewals of
existing maintenance contracts.

   International sales represented 35% of our total revenues in 2001, 32% in
2000, and 34% in 1999. The increase in international revenue in 2001 compared
to 2000 as a percentage of total revenue was due to a strong sales performance
in Europe, offset by under-performance in our Asia Pacific region. The decease
in international revenue from 1999 to 2000 was due to weakness in European
currencies and under-performance and the weak economy in Asia Pacific.

  Cost of revenue

   License cost of revenue includes costs of materials, product packaging and
shipping, equipment depreciation, production personnel, and costs associated
with our APM business. License cost of revenue increased to $24.2 million in
2001 from $17.1 million in 2000. License cost of revenue as a percentage of
license revenue increased to 10% in 2001 from 8% in 2000. The increase in
absolute dollars and as a percentage of license revenue was primarily due to
increased costs associated with our managed services business including,
personnel-related costs of $3.6 million reflecting growth in managed services
employees from 56 to 65, increased fees to providers of internet bandwidth and
related infrastructure of $2.0 million, and $900,000 in depreciation expense of
managed services equipment. We expect license cost of revenue to continue to
increase in absolute dollars but decease as a percentage of license revenues as
our base of APM customers grows and the amount of related subscription and
renewal revenue increases.

   License cost of revenue increased to $17.1 million in 2000 from $7.7 million
in 1999. License cost of revenue as a percentage of license revenue increased
to 8% in 2000 from 6% in 1999. The increase as a percentage of license revenue
was primarily due to our initial investment in managed services during 2000,
including $2.6 million in personnel-related costs, $1.9 million in internet
bandwidth and related intrastructure fees, and $900,000 in depreciation expense
of managed services equipment.

   Service cost of revenue consists primarily of costs of providing customer
technical support, training and consulting. Service cost of revenue increased
to $29.2 million in 2001 from $24.7 million in 2000. Service cost of revenue,
as a percentage of service revenue, decreased to 23% in 2001 from 27% in 2000.
The absolute dollar increase in service cost of revenue in 2001 as compared to
2000 was primarily due to increased personnel-related costs of $3.8 million
reflecting a higher average number of employees during 2001 and increased IT
infrastructure costs of $1.6 million, offset by a $1.8 million decrease in
services outsourcing costs. We expect service cost of revenue as a percentage
of service revenue to vary based on the degree of outsourcing of training and
consulting and the profitability of individual consulting engagements.

   Service cost of revenue increased to $24.7 million in 2000 from $17.0
million in 1999. As a percentage of service revenue, it decreased to 27% in
2000 from 30% in 1999. The absolute dollar increase in service cost of revenue
in 2000 as compared to 1999 was primarily due to an increase in
personnel-related costs of $5.0 million reflecting growth in customer support
and consulting employees from 156 at December 31, 1999 to 254 at December 31,
2000 and a $2.1 million increase in training and consulting outsourcing expense.

                                      16

<PAGE>

  Operating expenses

  Research and development

   Research and development expense consists primarily of costs associated with
the development of new products, enhancements of existing products, and quality
assurance procedures, and is comprised primarily of employee salaries and
related costs, consulting costs, equipment depreciation and facilities
expenses. For the year ended December 31, 2001, research and development
expense was $37.2 million, or 10% of total revenue, an increase from $32.0
million or 10% of total revenue in 2000. The absolute dollar increase in
research and development spending in 2001 as compared to 2000 was due to a $3.1
million increase in personnel-related costs, reflecting an increase in
employees from 318 to 350 to staff APM development activities, $1.0 million in
increased outsourcing and $700,000 for increased facilities expense. We expect
research and development expense to increase in absolute dollars in the future.

   For the year ended December 31, 2000, research and development was $32.0
million, or 10% of total revenue, an increase from $23.5 million, or 13% of
total revenue in 1999. The increase in absolute dollars of research and
development spending in 2000 as compared to 1999 reflected primarily an
increase in employees from 226 at December 31, 1999 to 316 at December 31, 2000
and increased salaries of research and development engineers.

  Marketing and selling

   Marketing and selling expense consists primarily of employee salaries and
related costs, sales commissions, facilities expenses and marketing programs.
Marketing and selling expense was $189.6 million or 53% of total revenue in
2001 compared to $151.9 million or 49% of total revenue in 2000 and $89.9
million or 48% of total revenue in 1999. The $37.7 million absolute dollar
increase in marketing and selling expense in 2001 as compared to 2000 included
an increase of $20.1 million in personnel-related costs, reflecting average
number of employees in 2001 of 792 compared to 534 average number of employees
in 2000. It also included spending increases in 2001 over 2000 of $4.4 million
for marketing programs, $4.2 million for IT and related infrastructure,
$3.2 million for facilities, $2.3 million for equipment depreciation, and $1.8
million for sales commissions. We expect marketing and selling expenses to
increase in absolute dollars but generally decrease as a percentage of revenue
in the future.

   Marketing and selling expenses were $151.9 million, or 49% of total revenue,
in 2000, compared to $89.9 million in 1999. The increase in expenses in 2000 as
compared to 1999 was primarily due to an increase in personnel-related costs of
$26.7 million reflecting growth in employees from 377 at December 31, 1999 to
632 at December 31, 2000, including the increase in sales employees related to
our cybersales organization and APM business. The increase in expenses in 2000
as compared to 1999 was also due to an increase in sales commissions of $17.9
million attributable to higher revenue, an increase in facilities and related
costs of $2.4 million and an increase in spending on marketing programs of $7.4
million.

  General and administrative

   General and administrative expense consists primarily of employee salaries
and related costs associated with administration and management personnel.
General and administrative expense increased to $23.1 million or 6% of total
revenue in 2001 from $17.8 million, or 6% of total revenue in 2000 and $11.7
million, or 6% of total revenue in 1999. The absolute dollar increase in
general and administrative spending was due to increased personnel-related
expenses of $1.8 million reflecting an increase in average number of employees
from 105 in 2000 to 131 in 2001, increased professional service fees of $2.0
million, and increased IT and infrastructure costs of $1.4 million.


                                      17

<PAGE>

   General and administrative expense increased to $17.8 million, or 6% of
total revenue in 2000, from $11.7 million, or 6% of total revenue in 1999. The
increase in the absolute dollars was primarily due to increased payroll-related
expense of $4.8 million reflecting increased employees of 119 in 2000 compared
to 80 in 1999, and increased professional service fees of $800,000.

  Restructuring, integration and other related charges

   Restructuring, integration and other related charges were $5.4 million in
2001 compared to zero in 2000. During the third quarter of 2001, in connection
with management's plan to reduce costs and improve operating efficiencies, we
recorded restructuring and other charges of $4.4 million, consisting of $2.9
million for employee reductions, $1.1 million for the cancellation of a
marketing event, and $400,000 for professional services and consolidation of
facilities. Employee reductions consisted of a reduction in force of
approximately 140 employees, or 8% of our worldwide workforce. Total cash
outlays associated with the restructuring are expected to be $4.2 million. The
remaining $0.2 million of costs consists of non-cash charges for asset
write-offs. During the year ended December 31, 2001, cash paid was $3.4
million. The majority of the remaining cash outlays of $770,000, which include
severance costs and fees associated with the cancellation of a marketing event,
occurred during the first quarter of 2002.

   During the second quarter of 2001, in conjunction with the acquisition of
Freshwater Software, Inc. ("Freshwater"), we also recorded a charge for certain
nonrecurring restructuring and integration costs of $946,000. The charge
included costs for consolidation of facilities, employee severance, and fixed
asset write-offs. We expect the remaining costs of $113,000 associated with the
charge to be paid during the first half of 2002.

   Restructuring, integration and other related charges were zero in 2000
compared to $2.0 million in 1999. In connection with the acquisition of Conduct
Ltd. in 1999, we incurred merger-related expenses primarily relating to legal
and accounting expenses, severance and the write-off of redundant facilities
and equipment. These restructuring costs were paid in 2000.

  Amortization of unearned stock-based compensation

   Amortization of unearned stock-based compensation in 2001 was $2.0 million
compared to zero in 2000 and 1999. During the second quarter of 2001, in
connection with the acquisition of Freshwater, we recorded unearned stock-based
compensation totaling $10.4 million associated with approximately 140,000
unvested stock options assumed. The options assumed were valued using the fair
market value of our stock on the date of acquisition, which was $72.21. We
reduced unearned stock-based compensation by $4.0 million due to the
termination of certain employees in conjunction with the third quarter
restructuring. We also recorded additional unearned stock-based compensation of
$341,000 in conjunction with the third quarter restructuring. The options were
valued using the fair market value of our stock on the date of accelerated
vesting, which was a weighted average of $32.92. Amortization of unearned
stock-based compensation for the year ended December 31, 2001 was $2.0 million.
We expect to amortize approximately $600,000 per quarter through the second
half of 2005 which is over the remaining vesting periods of the related options.

  Amortization of goodwill and other intangible assets

   Amortization of goodwill and other intangible assets was $30.1 million in
2001 compared to zero in 2000 and 1999. In May 2001, we acquired all of the
outstanding securities of Freshwater for cash consideration of $146.1 million.
The purchase price included $849,000 for the fair value of approximately 13,000
assumed Freshwater vested stock options, as well as direct acquisition costs of
$529,000. The fair value of options assumed were estimated using the
Black-Scholes model with the following assumptions: fair value of $74.21;
expected life (years) of four; risk-free interest rate of 4.41%; volatility of
92%; and dividend yield of zero percent. The allocation of the purchase price
resulted in an excess of purchase price over net tangible assets

                                      18

<PAGE>

acquired of $148.1 million. This was allocated, based on a third party
valuation, $2.1 million to workforce, $5.5 million to purchased technology and
$140.5 million to goodwill, including $3.0 million of goodwill for deferred tax
assets associated with the workforce and purchased technology. During 2001, the
goodwill and other intangible assets were amortized on a straight-line basis
over 3 years.

   In 2002, Statement of Financial Accounting Standards ( SFAS ) No. 142,
Goodwill and Other Intangible Assets became effective and as a result, we have
ceased to amortize approximately $109.5 million of goodwill and $1.7 million of
workforce and have reclassified the workforce to goodwill. We had recorded
approximately $28.4 million of amortization on these amounts during 2001 and
would have recorded approximately $46.5 million of amortization during 2002. In
lieu of amortization, we are required to perform a preliminary assessment of
our goodwill in 2002 and an annual impairment review thereafter and potentially
more frequently if circumstances change. We completed our preliminary
assessment during the first quarter of 2002 and did not record an impairment
charge. We also ceased to amortize the deferred tax asset associated with the
workforce of approximately $661,000. We had recorded approximately $169,000 of
amortization during 2001 and would have recorded approximately $277,000 during
2002. In lieu of amortization, we were required to offset the deferred tax
asset against the deferred tax liability. We expect to amortize approximately
$2.6 million of the purchased technology during the year ending December 31,
2002.

  Other income, net

   Other income, net consists primarily of interest income, interest expense
related to our convertible subordinated notes, and foreign exchange gains and
losses. Other income, net was $10.1 million in 2001 compared to $17.5 million
in 2000 and $6.0 million in 1999. The decrease in other income, net in 2001 as
compared to 2000 was primarily due to increased interest expense and
amortization of debt issuance costs of $12.9 million, partially offset by
increased interest income of $6.4 million due to a higher average annual
investment balance. The increase in other income in 2000 as compared to 1999
primarily reflected increased interest income of $23.5 million due to the
proceeds of the issuance of convertible subordinated notes in July 2000,
partially offset by interest expense and amortization of debt issuance costs on
the notes of $12.8 million.

   We adopted Statement of Financial Accounting Standard (SFAS) No. 133,
Accounting for Derivative Instruments and Hedging Activities, as amended, on
January 1, 2001. The standard requires us to recognize all derivatives on the
balance sheet at fair value. Derivatives that are not hedges must be adjusted
to fair value through the statement of operations. If the derivative is a
hedge, depending on the nature of the hedge, changes in the fair value of
derivatives will either be offset against the change in fair value of the
hedged assets, liabilities or firm commitments through earnings, or recognized
in other comprehensive income (loss) until the hedged item is recognized in
earnings. The ineffective portion of a derivative's change in fair value will
be immediately recognized in earnings. The accounting for gains or losses from
changes in fair value of a derivative instrument depends on whether it has been
designated and qualifies as part of a hedging relationship, as well as on the
type of hedging relationship. The adoption of SFAS No. 133 did not have a
material effect on our financial statements.

   In January 2002, we entered into an interest rate swap with respect to
$300.0 million of our 4.75% Convertible Subordinated Notes. The January
interest rate swap is designated as an effective hedge of the fair value of our
$300.0 million of 4.75% Convertible Subordinated Notes (the "Notes"). The
objective of the swap is to convert the 4.75% fixed interest rate on the Notes
to a variable interest rate based on the 6-month London Interbank Offered Rate
("the LIBOR rate") plus 86 basis points. The gain or loss from changes in the
fair value of the swap is expected to entirely offset the loss or gain from
changes in the fair value of the Notes throughout the life of the Notes. The
swap creates a market exposure to changes in the LIBOR rate. If the LIBOR rate
increases or decreases by 1%, our interest expense would increase or decrease
by $750,000 quarterly on a pretax basis. If the LIBOR rate does not change from
the rate of 1.84% at the inception of the swap, we would be able to reduce
interest expense from the current amount each quarter by approximately $1.5
million. Under the terms of the swap, we were required to provide initial
collateral in the form of cash or cash equivalents to Goldman Sachs Capital
Markets, L.P. ("GSCM") in the amount of $6.0 million as continuing security for
our obligations under

                                      19

<PAGE>

the swap (irrespective of movements in the value of the swap) and from time to
time additional collateral can change hands between Mercury and GSCM as swap
rates and equity prices fluctuate. We will account for the initial collateral
and any additional collateral as restricted cash on our balance sheet. As of
March 12, 2002, we were required to provide additional collateral of $6.0
million therefore our total restricted cash as of such date was $12.0 million.

   In February 2002, we entered into a second interest rate swap with GSCM that
does not qualify for hedge accounting treatment under SFAS 133 and therefore is
marked-to-market through other income each quarter. The life of this swap is
through July 1, 2007, the same date as the first swap and the original maturity
date of the Notes. The swap entitles us to receive approximately $608,000 from
GSCM semi-annually during the life of the swap, subject to the following
conditions:

  .  If the price of our common stock exceeds the original conversion or
     redemption price of the Notes, we will be required to pay the fixed rate
     of 4.75% and receive a variable rate on the $300.0 million principal
     amount of the Notes. We would no longer receive the $608,000 payment
     semi-annually.

  .  If we call the Notes at a premium (in whole or in part), or if any of the
     holders of the Notes elect to convert the Notes (in whole or in part), we
     will be required to pay a variable rate and receive the fixed rate of
     4.75% on the principal amount of such called or converted Notes. However,
     we would continue to receive the $608,000 from GSCM semi-annually provided
     that the price of our common stock during the life of the swap never
     exceeds the original conversion or redemption price of the Notes.

   We are exposed to credit exposure with respect to GSCM as counterparty under
both swaps. However, we believe that the risk of such credit exposure is
limited because GSCM is an affiliate of a major U.S. investment bank and
because its obligations under both swaps are guaranteed by the Goldman Sachs
Group L.P.

  Provision for income taxes

   We have structured our operations in a manner designed to maximize income in
Israel where tax rate incentives have been extended to encourage foreign
investments. The tax holidays and rate reductions, which we will be able to
realize under programs currently in effect, expire at various dates through
2012. Future provisions for taxes will depend upon the mix of worldwide income
and the tax rates in effect for various tax jurisdictions. The effective tax
rate for the year ended December 31, 2001 differs from statutory tax rates
principally because of the non-deductibility of charges for amortization of
goodwill and other intangible assets and stock-based compensation, and our
participation in special reduced taxation programs in Israel.

  Extraordinary item--gain on early retirement of debt, net of taxes

   In December 2001, our board of directors authorized a retirement program for
our convertible subordinated notes. Under the retirement program, we may
reacquire up to $200.0 million in face value of the notes. In the fourth
quarter of fiscal 2001, we paid $102.7 million including accrued interest, to
retire $122.5 million face value of the notes, which resulted in an
extraordinary gain on the early retirement of debt of $19.8 million plus other
related gains of $557,000 primarily related to the gain on sale of
held-to-maturity investments, net of related taxes of $4.1 million. As of
December 31, 2001, the notes had a remaining book value of $368.7 million.
Through February 28, 2002, we repurchased an additional $29.8 million in face
value for $24.9 million including accrued interest.

Liquidity and Capital Resources

   At December 31, 2001, our principal source of liquidity consisted of $588.9
million of cash and investments compared to $782.4 million at December 31, 2000
and $186.9 million at December 31, 1999. The December 31, 2001 balance included
$179.5 million of short-term and $161.1 million of long-term investments in
high quality financial, government, and corporate securities. The decrease in
cash and investments from 2001 compared to

                                      20

<PAGE>

2000 was primarily due to net cash paid in conjunction with the Freshwater
Software, Inc. acquisition of $144.0 million and the retirement of convertible
subordinated notes of $100.0 million (excluding accrued interest). During 2001,
we generated $83.0 million of cash from operating activities, compared to
$129.8 million in 2000 and $61.0 million in 1999. The decrease in cash from
operations from 2001 compared to 2000 was due primarily to a decrease in net
income. The increase in 2000 compared to 1999 was due primarily to an increase
in net income and increases in deferred revenue and accrued liabilities.

   During the year ended 2001, our investing activities consisted of net cash
paid in conjunction with the Freshwater acquisition of $144.0 million,
investments made in non-consolidated companies of $18.9 million and purchases
of property and equipment of $22.1 million offset by net proceeds from
investments of $215.4 million. We have committed to make additional capital
contributions to a private equity fund totaling $12.0 million and we expect to
pay approximately $9.0 million through March 31, 2003 as capital calls are
made. Our purchases of property and equipment included $2.3 million for the
renovation of headquarters buildings in Sunnyvale, as well as, $4.8 million for
the construction of research and development facilities in Israel. We expect to
spend an additional $5.0 million on the renovations of our buildings in
Sunnyvale and expect to spend an additional $3.8 million to complete the
construction of the Israel facility.

   During the year ended 2001, our primary financing activity consisted of uses
of cash for the retirement of convertible subordinated notes of $100.0 million
(excluding interest expense) and purchase of treasury stock of $16.1 million,
offset by cash proceeds from common stock under our employee stock option and
stock purchase plans, net of notes receivable collected from issuance of common
stock, of $25.1 million.

   In July 2000, we raised $485.4 million from the issuance of convertible
subordinated notes with an aggregate principal amount of $500.0 million. The
notes mature on July 1, 2007 and bear interest at a rate of 4.75% per annum,
payable semiannually on January 1 and July 1 of each year. The notes are
subordinated in right of payment to all of our future senior debt. The notes
are convertible into shares of our common stock at any time prior to maturity
at a conversion price of approximately $111.25 per share, subject to adjustment
under certain conditions. We may redeem our notes, in whole or in part, at any
time on or after July 1, 2003.

   In December 2001, the board of directors authorized a retirement program for
our convertible subordinated notes. Under the retirement program, we may
reacquire up to $200.0 million in face value of the notes. In the fourth
quarter of fiscal 2001, we paid $102.7 million, including accrued interest, to
retire $122.5 million face value of the notes, which resulting in an
extraordinary gain on the early retirement of debt of $19.8 million plus other
related gains of $557,000 primarily related to the gain on sale of
held-to-maturity investments, net of related taxes of $4.1 million. As of
December 31, 2001, the notes had a remaining book value of $368.7 million.
Through February 28, 2002, we repurchased an additional $29.8 million in face
value of the convertible subordinated notes for $24.9 million including accrued
interest.

   During 2001, a significant portion of our cash inflows were generated by our
operations. Because our operating results may fluctuate significantly, as a
result of decreases in customer demand or decreases in the acceptance of our
future products and services, our ability to generate positive cash flow from
operations may be jeopardized.

                                      21

<PAGE>

   Future payments due under debt and lease obligations as of December 31, 2001
are as follows (in thousands):

<TABLE>
<CAPTION>
                                          4.75%
                                       Convertible     Non
                                       Subordinated Cancelable
                                        Notes due   Operating
                                         2007(a)      Leases    Total
                                       ------------ ---------- --------
         <S>                           <C>          <C>        <C>
         2002.........................   $     --    $ 7,550   $  7,550
         2003.........................         --      5,800      5,800
         2004.........................         --      2,766      2,766
         2005.........................         --      1,225      1,225
         2006.........................         --        436        436
         Thereafter...................    377,480        281    377,761
                                         --------    -------   --------
                                         $377,480    $18,058   $395,538
                                         ========    =======   ========
</TABLE>
--------
(a) Assuming we do not retire additional convertible subordinated notes during
    2002, we will make interest payments net of interest rate swap of
    approximately $12.4 million during 2002, 2003, 2004, 2005, and 2006. We
    will make interest payments net of interest rate swap of approximately $6.2
    million during 2007.

   Assuming there is no significant change in our business, we believe that our
current cash and investment balances and cash flow from operations will be
sufficient to fund our cash needs for at least the next twelve months.

Critical Accounting Policies

   The methods, estimates and judgments we use in applying our most critical
accounting policies have a significant impact on the results we report in our
financial statements. The US Securities and Exchange Commission has defined the
most critical accounting policies as the ones that are most important to the
portrayal of our financial condition and results, and require us to make our
most difficult and subjective judgments, often as a result of the need to make
estimates of matters that are inherently uncertain.

   Our critical accounting policies are as follows:

  .  revenue recognition;

  .  estimating valuation allowances and accrued liabilities, specifically
     sales reserves;

  .  accounting for software development costs;

  .  valuation of long-lived and intangible assets and goodwill;

  .  accounting for income taxes;

  .  accounting for non-consolidated companies; and

  .  accounting for unearned stock-based compensation

   Below, we discuss these policies further, as well as the estimates and
judgments involved. We also have other key accounting policies. We believe that
these other policies either do not generally require us to make estimates and
judgments that are as difficult or as subjective, or it is less likely that
they would have a material impact on our reported results of operations for a
given period.

  Revenue recognition

   We derive our revenue from primarily two sources (i) product revenue, which
consists of software license fees and hosted software arrangements and (ii)
services and support revenue which includes software license

                                      22

<PAGE>

maintenance, training, and consulting. We license our software products on a
term basis or on a perpetual basis. Our hosted software arrangements require
customers to pay a fixed fee and receive service over a period of time,
generally one or two years. Customers do not pay any set up fee.

   We recognize revenue from the sale of software licenses when persuasive
evidence of an arrangement exists, the product has been delivered, the fee is
fixed and determinable and collection of the resulting receivable is probable.
Delivery generally occurs when product is delivered to a common carrier. At the
time of the transaction, we assess whether the fee associated with our revenue
transactions is fixed and determinable and whether or not collection is
probable. We assess whether the fee is fixed and determinable based on the
payment terms associated with the transaction. If a significant portion of a
fee is due after our normal payment terms, which are 30 to 60 days from invoice
date, we account for the fee as not being fixed and determinable. In these
cases, we recognize revenue as the fees become due. We assess collection based
on a number of factors, including past transaction history with the customer
and the credit-worthiness of the customer. We do not request collateral from
our customers. If we determine that collection of a fee is not probable, we
defer the fee and recognize revenue at the time collection becomes probable,
which is generally upon receipt of cash. For all sales, except those completed
over the Internet, we use either a customer order document or signed license or
service agreement as evidence of an arrangement. For sales over the Internet,
we use a credit card authorization as evidence of an arrangement.

   For arrangements with multiple obligations (for example, undelivered
maintenance and support), we allocate revenue to each component of the
arrangement using the residual value method based on the fair value of the
undelivered elements, which is specific to us. This means that we defer revenue
from the arrangement fee equivalent to the fair value of the undelivered
elements. Fair values for the ongoing maintenance and support obligations for
our licenses are based upon separate sales of renewals to other customers or
upon renewal rates quoted in the contracts. Fair value of services, such as
training or consulting, are based upon separate sales by us of these services
to other customers. Most of our arrangements involve multiple obligations. Our
arrangements do not generally include acceptance clauses. However, if an
arrangement includes an acceptance provision, acceptance occurs upon the
earlier of receipt of a written customer acceptance or expiration of the
acceptance period. We recognize revenue for maintenance services ratably over
the contract term. Our training and consulting services are billed based on
hourly rates, and we generally recognize revenue as these services are
performed.

  Estimating valuation allowances and accrued liabilities, specifically sales
  reserves

   The preparation of financial statements requires our management to make
estimates and assumptions that affect the reported amount of assets and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reported period. Specifically, our management must make estimates of potential
future product returns and write off of bad debt accounts related to current
period product revenue. Management analyzes historical returns, historical bad
debts, current economic trends, and changes in customer demand and acceptance
of our products when evaluating the adequacy of the sales reserves. Significant
management judgments and estimates must be made and used in connection with
establishing the sales reserves in any accounting period. Material differences
may result in the amount and timing of our revenue for any period if management
made different judgments or utilized different estimates. The provision for
sales reserves amounted to $6.2 million at December 31, 2001.

  Accounting for software development costs

   Costs incurred in the research and development of new software products are
expensed as incurred until technological feasibility is established.
Development costs are capitalized beginning when a product's technological
feasibility has been established and ending when the product is available for
general release to customers. Technological feasibility is reached when the
product reaches the working model stage. To date, products and enhancements
have generally reached technological feasibility and have been released for
sale at

                                      23

<PAGE>

substantially the same time and all research and development costs have been
expensed. Consequently, no research and development costs were capitalized in
2001.

  Valuation of long-lived and intangible assets and goodwill

   For certain long-lived assets, primarily fixed assets and goodwill and
intangible assets, we are required to estimate the useful life of the asset and
recognize its costs as an expense over the useful life. We use the
straight-line method to expense long-lived assets, which results in an equal
amount of expense in each period.

   We are required to assess the impairment of identifiable intangibles,
long-lived assets and goodwill and on an annual basis, and potentially more
frequently if events or changes in circumstances indicate that the carrying
value may not be recoverable. Factors we consider important which could trigger
an impairment review include the following:

  .  significant underperformance relative to expected historical or projected
     future operating results;

  .  significant changes in the manner of our use of the acquired assets or the
     strategy for our overall business;

  .  significant negative industry or economic trends;

  .  significant decline in our stock price for a sustained period; and

  .  our market capitalization relative to net book value.

   When we determine that the carrying value of intangibles, long-lived assets
or goodwill may not be recoverable based upon the existence of one or more of
the above indicators of impairment, we measure any impairment based on a
projected discounted cash flow method using a discount rate determined by our
management to be commensurate with the risk inherent in our current business
model. Net intangible assets, long-lived assets, and goodwill amounted to
$126.7 million as of December 31, 2001.

  Accounting for income taxes

   As part of the process of preparing our consolidated financial statements we
are required to estimate our income tax expense in each of the jurisdictions in
which we operate. This process involves us estimating our actual current tax
exposure together with assessing temporary differences resulting from differing
treatment of items, such as deferred revenue, for tax and accounting purposes.
These differences result in deferred tax assets and liabilities, which are
included within our consolidated balance sheet. We must then assess the
likelihood that our deferred tax assets will be recovered from future taxable
income and to the extent we believe that recovery is not likely, we must
establish a valuation allowance. To the extent we establish a valuation
allowance or increase this allowance in a period, we must include an expense
within the tax provision in the statement of operations.

   Significant management judgment is required in determining our provision for
income taxes, our deferred tax assets and liabilities and any valuation
allowance recorded against our net deferred tax assets. We have not recorded a
valuation allowance as of December 31, 2001, because we believe it is more
likely than not that all deferred tax assets will be realized in the
foreseeable future. In the event that actual results differ from these
estimates or we adjust these estimates in future periods we may need to
establish an additional valuation allowance which could materially impact our
financial position and results of operations. The deferred tax asset as of
December 31, 2001 was $5.2 million.

  Accounting for non-consolidated companies

   We make venture capital investments in early stage private companies and
private equity funds for business and strategic purposes. These investments are
accounted for under the cost method, as we do not have the ability to exercise
significant influence over these companies' operations. We monitor our
investments for impairment and will record reductions in carrying values if and
when necessary. This policy includes, but is not limited to,

                                      24

<PAGE>

reviewing each of the companies' cash position, financing needs,
earnings/revenue outlook, operational performance, management/ownership
changes, and competition. The evaluation process is based on information that
we request from these privately-held companies. This information is not subject
to the same disclosure regulations as US public companies, and as such, the
basis for these evaluations is subject to the timing and the accuracy of the
data received from these companies. If we believe that the carrying value of a
company is carried at an amount in excess of fair value, it is our policy to
record a reserve and the related writedown is recorded as an investment loss on
our consolidated statements of income. Estimating the fair value of
non-marketable equity investments in early-stage technology companies is
inherently subjective and may contribute to significant volatility in our
reported results of operations.

   As of December 31, 2001, we had invested $18.9 million in private companies.
In addition, we have committed to make capital contributions to a venture
capital fund totaling $12.0 million and we expect to pay approximately $9.0
million through March 31, 2003 as capital calls are made. If the companies in
which we have made investments do not complete initial public offerings or are
not acquired by publicly traded companies or for cash, we may not be able to
sell these investments. In addition, even if we are able to sell these
investments we cannot assure that we will be able to sell them at a gain or
even recover our investment. The recent general decline in the Nasdaq National
Market and the market prices of publicly traded technology companies, as well
as any additional declines in the future, will adversely affect our ability to
realize gains or a return of our capital on many of these investments.

  Accounting for unearned stock-based compensation

   We amortize stock-based compensation using the straight-line approach over
the remaining vesting periods of the related options, which is generally four
years. Pro forma information regarding net income and earnings per share is
required. This information is required to be determined as if we had accounted
for employee stock options and stock purchase plans under the fair value method
of that statement.

   The fair value of options and shares issued pursuant to the option plans and
the Employee Stock Purchase Plan ("ESPP") at the grant date were estimated
using the Black-Scholes model. The Black-Scholes option pricing model was
developed for use in estimating the fair value of traded options that have no
vesting restrictions and are fully transferable. In addition, option pricing
models require the input of highly subjective assumptions including the
expected stock price volatility. We use projected volatility rates, which are
based upon historical volatility rates trended into future years. Because our
employee stock options have characteristics significantly different from those
of traded options, and because changes in the subjective input assumptions can
materially affect the fair value estimate, in management's opinion, the
existing models do not necessarily provide a reliable single measure of the
fair value of our options. The weighted average fair valuation per share of
options granted under the option plans during the year ended December 31, 2001
was $27.03.

   The effects of applying pro forma disclosures of net income and earnings per
share for the fiscal years ended 2001, 2000 and 1999 are not likely to be
representative of the pro forma effects on net income and earnings per share in
the future years for the following reasons: 1) the number of future shares to
be issued under these plans are not known and 2) the assumptions used to
determine the fair value can vary significantly.

Recent Accounting Pronouncements

   In May 2000, the Emerging Issues Task Force (EITF) issued EITF Issue No.
00-14, Accounting for Certain Sales Incentives. EITF Issue No. 00-14 addresses
the recognition, measurement, and income statement classification for sales
incentives that a vendor voluntarily offers to customers (without charge),
which the customer can use in, or exercise as a result of, a single exchange
transaction. Sales incentives that fall within the scope of EITF Issue No.
00-14 include offers that a customer can use to receive a reduction in the
price of a product or service at the point of sale. The EITF changed the
transition date for Issue 00-14, concluding that a company should apply this
consensus no later than the company's annual or interim financial statements
for the periods beginning after December 15, 2001.

                                      25

<PAGE>

   In June 2001, the EITF issued EITF Issue No. 00-25, Vendor Income Statement
Characterization of Consideration Paid to a Reseller of the Vendor's Products,
effective for periods beginning after December 15, 2001. EITF Issue No. 00-25
addresses whether consideration from a vendor to a reseller is (a) an
adjustment of the selling prices of the vendor's products and, therefore,
should be deducted from revenue when recognized in the vendor's statement of
operations or (b) a cost incurred by the vendor for assets or services received
from the reseller and, therefore, should be included as a cost or expense when
recognized in the vendor's statement of operations. Upon application of these
EITFs, financial statements for prior periods presented for comparative
purposes should be reclassified to comply with the income statement display
requirements under these Issues.

   In September of 2001, the EITF issued EITF Issue No. 01-09, Accounting for
Consideration Given by Vendor to a Customer or a Reseller of the Vendor's
Products, which is a codification of EITF Issues No. 00-14, No. 00-25 and No.
00-22, Accounting for Points and Certain Other Time-or Volume-Based Sales
Incentive Offers and Offers for Free Products or Services to be Delivered in
the Future. We are currently assessing the impact of the adoption of these
issues on our financial statements.

   In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS
No. 141, Business Combinations. SFAS No. 141 requires the purchase method of
accounting for business combinations initiated after June 30, 2001 and
eliminates the pooling-of-interests method. The adoption of SFAS No. 141 did
not have a significant impact on our financial statements.

   In 2002, Statement of Financial Accounting Standards ( SFAS ) No. 142,
Goodwill and Other Intangible Assets became effective and as a result, we have
ceased to amortize approximately $109.5 million of goodwill and $1.7 million of
workforce and have reclassified the workforce to goodwill. We had recorded
approximately $28.4 million of amortization on these amounts during 2001 and
would have recorded approximately $46.5 million of amortization during 2002. In
lieu of amortization, we are required to perform a preliminary assessment of
our goodwill in 2002 and an annual impairment review thereafter and potentially
more frequently if circumstances change. We completed our preliminary
assessment during the first quarter of 2002 and did not record an impairment
charge. We also ceased to amortize the deferred tax asset associated with the
workforce of approximately $661,000. We had recorded approximately $169,000 of
amortization during 2001 and would have recorded approximately $277,000 during
2002. In lieu of amortization, we were required to offset the deferred tax
asset against the deferred tax liability. In lieu of amortization, we are
required to remove the deferred tax asset and the corresponding amount from the
deferred tax liability. We expect to amortize approximately $2.6 million of the
purchased technology during the year ended December 31, 2002.

   The impairment review involves a two-step process as follows:

  .  Step 1--we will compare the fair value of our reporting units to the
     carrying value, including goodwill of each of those units. For each
     reporting unit where the carrying value, including goodwill, exceeds the
     unit's fair value, the Company will move on to step 2. If a unit's fair
     value exceeds the carrying value, no further work is performed and no
     impairment charge is necessary.

  .  Step 2--we will perform an allocation of the fair value of the reporting
     unit to its identifiable tangible and non-goodwill intangible assets and
     liabilities. This will derive an implied fair value for the reporting
     unit's goodwill. The Company will then compare the implied fair value of
     the reporting unit's goodwill with the carrying amount of the reporting
     unit's goodwill. If the carrying amount of the reporting unit's goodwill
     is greater than the implied fair value of its goodwill, an impairment loss
     must be recognized for the excess.

   In October 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets". SFAS No. 144 addresses
significant issues relating to the implementation of SFAS No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be
Disposed Of", and develops a single accounting method under which long-lived
assets that are to be disposed of by sale are measured at the lower of book
value or fair value less cost to sell. Additionally, SFAS No. 144 expands the
scope of discontinued operations to include all components of an entity with
operations that (1) can be distinguished

                                      26

<PAGE>

from the rest of the entity and (2) will be eliminated from the ongoing
operations of the entity in a disposal transaction. SFAS No. 144 is effective
for financial statements issued for fiscal years beginning after December 15,
2001 and its provisions are to be applied prospectively. The adoption of SFAS
No. 144 did not have a significant impact on our financial statements.

Risk Factors

   In addition to the other information included in this Annual Report on Form
10-K, the following risk factors should be considered carefully in evaluating
us and our business.

   Our future success depends on our ability to respond to rapid market and
technological changes by introducing new products and services and continually
improving the performance, features and reliability of our existing products
and services and responding to competitive offerings. Our business will suffer
if we do not successfully respond to rapid technological changes. The market
for our software products and services is characterized by:

  .  rapidly changing technology;

  .  frequent introduction of new products and services and enhancements to
     existing products and services by our competitors;

  .  increasing complexity and interdependence of our applications;

  .  changes in industry standards and practices; and

  .  changes in customer requirements and demands.

   To maintain our competitive position, we must continue to enhance our
existing software testing and application performance management products and
services and to develop new products and services, functionality and technology
that address the increasingly sophisticated and varied needs of our prospective
customers. The development of new products and services, and enhancement of
existing products and services, entail significant technical and business risks
and require substantial lead-time and significant investments in product
development. If we fail to anticipate new technology developments, customer
requirements or industry standards, or if we are unable to develop new products
and services that adequately address these new developments, requirements and
standards in a timely manner, our products may become obsolete, our ability to
compete may be impaired and our revenues could decline.

   We expect our quarterly revenues and operating results to fluctuate, and it
is difficult to predict our future revenues and operating results.  Our
revenues and operating results have varied in the past and are likely to vary
significantly from quarter to quarter in the future. These fluctuations are due
to a number of factors, many of which are outside of our control, including:

  .  fluctuations in demand for and sales of our products and services;

  .  our success in developing and introducing new products and services and
     the timing of new product and service introductions;

  .  our ability to introduce enhancements to our existing products and
     services in a timely manner;

  .  changes in economic conditions affecting our customers or our industry;

  .  changes in the mix of products or services sold in a quarter;

  .  the introduction of new or enhanced products and services by our
     competitors and changes in the pricing policies of these competitors;

  .  the discretionary nature of our customers' purchase and budget cycles and
     changes in their budgets for software and -related purchases;

                                      27

<PAGE>

  .  the amount and timing of operating costs and capital expenditures relating
     to the expansion of our business;

  .  deferrals by our customers of orders in anticipation of new products or
     services or product enhancements; and

  .  the mix of our domestic and international sales, together with
     fluctuations in foreign currency exchange rates.

   In addition, the timing of our license revenues is difficult to predict
because our sales cycles are typically short and can vary substantially from
product to product and customer to customer. We base our operating expenses on
our expectations regarding future revenue levels. As a result, if total
revenues for a particular quarter are below our expectations, we could not
proportionately reduce operating expenses for that quarter.

   We have experienced seasonality in our revenues and earnings, with the
fourth quarter of the year typically having the highest revenue and earnings
for the year and higher revenue and earnings than the first quarter of the
following year. We believe that this seasonality results primarily from the
budgeting cycles of our customers and from the structure of our sales
commission program. We expect this seasonality to continue in the future. In
addition, our customers' decisions to purchase our products and services are
discretionary and subject to their internal budgets and purchasing processes.
We believe that the slowdown in the economy, the terrorist activity on
September 11, 2001, and the ensuing declaration of the war on terrorism has
caused and may continue to cause customers to reassess their immediate
technology needs and to defer purchasing decisions, and accordingly has reduced
and could reduce demand in the future for our products and services.

   Due to these and other factors, we believe that period-to-period comparisons
of our results of operations are not necessarily meaningful and should not be
relied upon as indications of future performance. If our operating results are
below the expectations of investors or securities analysts, the trading prices
of our securities could decline.

   We expect to face increasing competition in the future, which could cause
reduced sales levels and result in price reductions, reduced gross margins or
loss of market share.  The market for our testing, tuning and application
performance management products and services is extremely competitive, dynamic
and subject to frequent technological changes. There are few substantial
barriers of entry in our market. In addition, the use of the Internet for a
growing range of applications is a recent and emerging phenomenon. The Internet
lowers the barriers of entry, allowing other companies to compete with us in
the testing and application performance management markets. As a result of the
increased competition, our success will depend, in large part, on our ability
to identify and respond to the needs of potential customers, and to new
technological and market opportunities, before our competitors identify and
respond to these needs and opportunities. We may fail to respond quickly enough
to these needs and opportunities.

   In the market for enterprise testing solutions, our principal competitors
include Compuware, Empirix, Radview, Rational Software, and Segue Software. In
the new and rapidly changing market for application performance management
solutions, our principal competitors include providers of managed services such
as Gomez and Keynote Systems, established providers of systems and network
management software such as BMC Software, Computer Associates, HP OpenView and
Tivoli, a division of IBM, and emerging companies. Additionally, we face
potential competition in this market from existing providers of testing
solutions such as Segue Software and Compuware.

   The software industry is increasingly experiencing consolidation and this
could increase the resources available to our competitors and the scope of
their product offerings. Our competitors and potential competitors may
undertake more extensive marketing campaigns, adopt more aggressive pricing
policies or make more attractive offers to distribution partners and to
employees.

   If we fail to maintain our existing distribution channels and develop
additional channels in the future, our revenues could decline.  We derive a
substantial portion of our revenues from sales of our products through

                                      28

<PAGE>

distribution channels such as systems integrators or value-added resellers. We
expect that sales of our products through these channels will continue to
account for a substantial portion of our revenues for the foreseeable future.
We may not experience increased revenues from these new channels, which could
harm our business.

   The loss of one or more of our systems integrators or value-added resellers,
or any reduction or delay in their sales of our products and services could
result in reductions in our revenue in future periods. In addition, our ability
to increase our revenue in the future depends on our ability to expand our
indirect distribution channels.

   Our dependence on indirect distribution channels presents a number of risks,
including:

  .  each of our systems integrators or value-added resellers, can cease
     marketing our products and services with limited or no notice and with
     little or no penalty;

  .  our existing systems integrators or value-added resellers, may not be able
     to effectively sell any new products and services that we may introduce;

  .  we may not be able to replace existing or recruit additional systems
     integrators or value-added resellers, if we lose any of our existing ones;

  .  our systems integrators or value-added resellers, may also offer
     competitive products and services from third parties;

  .  we may face conflicts between the activities of our indirect channels and
     our direct sales and marketing activities; and

  .  our systems integrators or value-added resellers, may not give priority to
     the marketing of our products and services as compared to our competitors'
     products.

   We depend on strategic relationships and business alliances for continued
growth of our business.  Our development, marketing and distribution strategies
rely increasingly on our ability to form strategic relationships with software
and other technology companies. These business relationships often consist of
cooperative marketing programs, joint customer seminars, lead referrals and
cooperation in product development. Many of these relationships are not
contractual and depend on the continued voluntary cooperation of each party
with us. Divergence in strategy or change in focus by, or competitive product
offerings by, any of these companies may interfere with our ability to develop,
market, sell or support our products, which in turn could harm our business.
Further, if these companies enter into strategic alliances with other companies
or are acquired, they could reduce their support of our products. Our existing
relationships may be jeopardized if we enter into alliances with competitors of
our strategic partners. In addition, one or more of these companies may use the
information they gain from their relationship with us to develop or market
competing products.

   If we are unable to manage rapid changes in our business, our business may
be harmed.  From 1991 through 2000, we experienced significant annual increases
in revenue, employees and number of product and service offerings. This growth
has placed and, if it is renewed, will place a significant strain on our
management and our financial, operational, marketing and sales systems. During
2001, we reduced 8% of our workforce. If we cannot manage rapid changes in our
business environment effectively, our business, competitive position, operating
results and financial condition could suffer. Although we are implementing a
variety of new or expanded business and financial systems, procedures and
controls, including the improvement of our sales and customer support systems,
the implementation of these systems, procedures and controls may not be
completed successfully, or may disrupt our operations. Any failure by us to
properly manage these transitions could impair our ability to attract and
service customers and could cause us to incur higher operating costs and
experience delays in the execution of our business plan. Conversely, if we fail
to reduce staffing levels when necessary, our costs would be excessive and our
business and operating results could be adversely affected.

   The success of our business depends on the efforts and abilities of our
senior management and other key personnel.  We depend on the continued services
and performance of our senior management and other key

                                      29

<PAGE>

personnel. We do not have long term employment agreements with any of our key
personnel. The loss of any of our executive officers or other key employees
could hurt our business. The loss of senior personnel can result in significant
disruption to our ongoing operations, and new senior personnel must spend a
significant amount of time learning our business and our systems in addition to
performing their regular duties.

   If we cannot hire qualified personnel, our ability to manage our business,
develop new products and increase our revenues will suffer.  We believe that
our ability to attract and retain qualified personnel at all levels in our
organization is essential to the successful management of our growth. In
particular, our ability to achieve revenue growth in the future will depend in
large part on our success in expanding our direct sales force and in
maintaining a high level of technical consulting, training and customer
support. There is substantial competition for experienced personnel in the
software and technology industry. If we are unable to retain our existing key
personnel or attract and retain additional qualified individuals, we may from
time to time experience inadequate levels of staffing to perform services for
our customers. As a result, our growth could be limited due to our lack of
capacity to develop and market our products to our customers.

   We depend on our international operations for a substantial portion of our
revenues.  Sales to customers located outside the US have historically
accounted for a significant percentage of our revenue and we anticipate that
such sales will continue to be a significant percentage of our revenue. As a
percentage of our total revenues, sales to customers outside the US was 35% in
2001, 32% in 2000 and 34% in 1999. In addition, we have substantial research
and development operations in Israel. We face risks associated with our
international operations, including:

  .  changes in taxes and regulatory requirements;

  .  difficulties in staffing and managing foreign operations;

  .  reduced protection for intellectual property rights in some countries;

  .  the need to localize products for sale in international markets;
  .  longer payment cycles to collect accounts receivable in some countries;

  .  seasonal reductions in business activity in other parts of the world in
     which we operate;

  .  political and economic instability; and

  .  economic downturns in international markets.

   Any of these risks could harm our international operations and cause lower
international sales. For example, some European countries already have laws and
regulations related to technologies used on the Internet that are more strict
than those currently in force in the US. Any or all of these factors could
cause our business to be harmed.

   Because our research and development operations are primarily located in
Israel, we may be affected by volatile political, economic, and military
conditions in that country and by restrictions imposed by that country on the
transfer of technology.  Our operations depend on the availability of highly
skilled scientific and technical personnel in Israel. Our business also depends
on trading relationships between Israel and other countries. In addition to the
risks associated with international sales and operations generally, our
operations could be adversely affected if major hostilities involving Israel
should occur or if trade between Israel and its current trading partners were
interrupted or curtailed.

   These risks are compounded due to the restrictions on our ability to
manufacture or transfer outside of Israel any technology developed under
research and development grants from the government of Israel, without the
prior written consent of the government of Israel. If we are unable to obtain
the consent of the government of Israel, we may not be able to take advantage
of strategic manufacturing and other opportunities outside of Israel. We have,
in the past, obtained royalty-bearing grants from various Israeli government
agencies. In addition, we

                                      30

<PAGE>

participate in special Israeli government programs that provide significant tax
advantages. The loss of, or any material decrease in, these tax benefits could
negatively affect our financial results.

   We are subject to the risk of increased taxes.  We have structured our
operations in a manner designed to maximize income in Israel where tax rate
incentives have been extended to encourage foreign investment. Our taxes could
increase if these tax rate incentives are not renewed upon expiration or tax
rates applicable to us are increased. Tax authorities could challenge the
manner in which profits are allocated among us and our subsidiaries, and we may
not prevail in any such challenge. If the profits recognized by our
subsidiaries in jurisdictions where taxes are lower became subject to income
taxes in other jurisdictions, our worldwide effective tax rate would increase.

   Our financial results may be negatively impacted by foreign currency
fluctuations.  Our foreign operations are generally transacted through our
international sales subsidiaries. As a result, these sales and related expenses
are denominated in currencies other than the US dollar. Because our financial
results are reported in US dollars, our results of operations may be harmed by
fluctuations in the rates of exchange between the US dollar and other
currencies, including:

  .  a decrease in the value of Pacific Rim or European currencies relative to
     the US dollar, which would decrease our reported US dollar revenue, as we
     generate revenues in these local currencies and report the related
     revenues in US dollars; and

  .  an increase in the value of Pacific Rim, European or Israeli currencies
     relative to the US dollar, which would increase our sales and marketing
     costs in these countries and would increase research and development costs
     in Israel.

   We attempt to limit foreign exchange exposure through operational strategies
and by using forward contracts to offset the effects of exchange rate changes
on intercompany trade balances. This requires us to estimate the volume of
transactions in various currencies. We may not be successful in making these
estimates. If these estimates are overstated or understated during periods of
currency volatility, we could experience material currency gains or losses.

   Our ability to successfully implement our business strategy depends on the
continued growth of the Internet.   In order for our business to be successful,
the Internet must continue to grow as a medium for conducting business.
However, as the Internet continues to experience significant growth in the
number of users and the complexity of Web-based applications, the Internet
infrastructure may not be able to support the demands placed on it or the
performance or reliability of the Internet might be adversely affected.
Security and privacy concerns may also slow the growth of the Internet. Because
our revenues ultimately depend upon the Internet generally, our business may
suffer as a result of limited or reduced growth.

   Acquisitions may be difficult to integrate, disrupt our business, dilute
stockholder value or divert the attention of our management and investments may
become impaired and require us to take a charge against earnings.  In May 2001
we acquired Freshwater Software, Inc. and we have minority investments in
private companies and venture capital funds of $18.9 million and we may acquire
or make investments in other companies and technologies. In the event of any
future acquisitions or investments, we could:

  .  issue stock that would dilute the ownership of our then-existing
     stockholders;

  .  incur debt;

  .  assume liabilities;

  .  incur charges for the impairment of the value of investments or acquired
     assets; or

  .  incur amortization expense related to intangible assets.

                                      31

<PAGE>

   If we fail to achieve the financial and strategic benefits of past and
future acquisitions or investments, our operating results will suffer.
Acquisitions and investments involve numerous other risks, including:

  .  difficulties integrating the acquired operations, technologies or products
     with ours;

  .  failure to achieve targeted synergies;

  .  unanticipated costs and liabilities;

  .  diversion of management's attention from our core business;

  .  adverse effects on our existing business relationships with suppliers and
     customers or those of the acquired organization;

  .  difficulties entering markets in which we have no or limited prior
     experience; and

  .  potential loss of key employees, particularly those of the acquired
     organizations.

   The price of our common stock may fluctuate significantly, which may result
in losses for investors and possible lawsuits.  The market price for our common
stock has been and may continue to be volatile. For example, during the 52-week
period ended February 28, 2002, the closing prices of our common stock as
reported on the Nasdaq National Market ranged from a high of $74.21 to a low of
$18.71. We expect our stock price to be subject to fluctuations as a result of
a variety of factors, including factors beyond our control. These factors
include:

  .  actual or anticipated variations in our quarterly operating results;

  .  announcements of technological innovations or new products or services by
     us or our competitors;

  .  announcements relating to strategic relationships, acquisitions or
     investments;

  .  changes in financial estimates or other statements by securities analysts;

  .  changes in general economic conditions;

  .  terrorist attacks, bio-terrorism and the war on terrorism;

  .  conditions or trends affecting the software industry and the Internet; and

  .  changes in the economic performance and/or market valuations of other
     software and high-technology companies.

   Because of this volatility, we may fail to meet the expectations of our
stockholders or of securities analysts at some time in the future, and the
trading prices of our securities could decline as a result. In addition, the
stock market has experienced significant price and volume fluctuations that
have particularly affected the trading prices of equity securities of many
high-technology companies. These fluctuations have often been unrelated or
disproportionate to the operating performance of these companies. Any negative
change in the public's perception of software or Internet software companies
could depress our stock price regardless of our operating results.

   If we fail to adequately protect our proprietary rights and intellectual
property, we may lose a valuable asset, experience reduced revenues and incur
costly litigation to protect our rights.  We rely on a combination of patents,
copyrights, trademarks, service marks and trade secret laws and contractual
restrictions to establish and protect our proprietary rights in our products
and services. We will not be able to protect our intellectual property if we
are unable to enforce our rights or if we do not detect unauthorized use of our
intellectual property. Despite our precautions, it may be possible for
unauthorized third parties to copy our products and use information that we
regard as proprietary to create products that compete with ours. Some license
provisions protecting against unauthorized use, copying, transfer and
disclosure of our licensed programs may be unenforceable under the laws of
certain jurisdictions and foreign countries. Further, the laws of some countries

                                      32

<PAGE>

do not protect proprietary rights to the same extent as the laws of the US. To
the extent that we increase our international activities, our exposure to
unauthorized copying and use of our products and proprietary information will
increase.

   In many cases, we enter into confidentiality or license agreements with our
employees and consultants and with the customers and corporations with whom we
have strategic relationships and business alliances. No assurance can be given
that these agreements will be effective in controlling access to and
distribution of our products and proprietary information. Further, these
agreements do not prevent our competitors from independently developing
technologies that are substantially equivalent or superior to our products.

   Litigation may be necessary in the future to enforce our intellectual
property rights and to protect our trade secrets. Litigation, whether
successful or unsuccessful, could result in substantial costs and diversions of
our management resources, either of which could seriously harm our business.

   Third parties could assert that our products and services infringe their
intellectual property rights, which could expose us to litigation that, with or
without merit, could be costly to defend.  We may from time to time be subject
to claims of infringement of other parties' proprietary rights. We could incur
substantial costs in defending ourselves and our customers against these
claims. Parties making these claims may be able to obtain injunctive or other
equitable relief that could effectively block our ability to sell our products
in the US and abroad and could result in an award of substantial damages
against us. In the event of a claim of infringement, we may be required to
obtain licenses from third parties, develop alternative technology or to alter
our products or processes or cease activities that infringe the intellectual
property rights of third parties. If we are required to obtain licenses, we
cannot be sure that we will be able to do so at a commercially reasonable cost,
or at all. Defense of any lawsuit or failure to obtain required licenses could
delay shipment of our products and increase our costs. In addition, any such
lawsuit could result in our incurring significant costs or the diversion of the
attention of our management.

   Defects in our products may subject us to product liability claims and make
it more difficult for us to achieve market acceptance for these products, which
could harm our operating results. Our products may contain errors or "bugs"
that may be detected at any point in the life of the product. Any future
product defects discovered after shipment of our products could result in loss
of revenues and a delay in the market acceptance of these products that could
adversely impact our future operating results.

   In selling our products, we frequently rely on "shrink wrap" or "click wrap"
licenses that are not signed by licensees. Under the laws of various
jurisdictions, the provisions in these licenses limiting our exposure to
potential product liability claims may be unenforceable. We currently carry
errors and omissions insurance against such claims, however, we cannot assure
you that this insurance will continue to be available on commercially
reasonable terms, or at all, or that this insurance will provide us with
adequate protection against product liability and other claims. In the event of
a product liability claim, we may be found liable and required to pay damages
which would seriously harm our business.

   We have adopted anti-takeover defenses that could delay or prevent an
acquisition of our company, including an acquisition that would be beneficial
to our stockholders.  Our board of directors has the authority to issue up to
5,000,000 shares of preferred stock and to determine the price, rights,
preferences and privileges of those shares without any further vote or action
by the stockholders. The rights of the holders of common stock will be subject
to, and may be adversely affected by, the rights of the holders of any
preferred stock that may be issued in the future. The issuance of preferred
stock, while providing desirable flexibility in connection with possible
acquisitions and other corporate purposes, could have the effect of making it
more difficult for a third party to acquire a majority of our outstanding
voting stock. We have no present plans to issue shares of preferred stock.
Furthermore, certain provisions of our Certificate of Incorporation and of
Delaware law may have the effect of delaying or preventing changes in our
control or management, which could adversely affect the market price of our
common stock.

                                      33

<PAGE>

   Leverage and debt service obligations may adversely affect our cash
flow.  In July 2000, we completed an offering of convertible subordinated notes
with a principal amount of $500.0 million. We repurchased $152.3 million of
principal amount of our convertible subordinated notes from December 18, 2001
through February 28, 2002. We continue to have a substantial amount of
outstanding indebtedness, primarily the convertible subordinated notes. There
is the possibility that we may be unable to generate cash sufficient to pay the
principal of, interest on and other amounts due in respect of our indebtedness
when due. Our leverage could have significant negative consequences, including:

  .  increasing our vulnerability to general adverse economic and industry
     conditions;

  .  requiring the dedication of a substantial portion of our expected cash
     flow from operations to service our indebtedness, thereby reducing the
     amount of our expected cash flow available for other purposes, including
     capital expenditures; and

  .  limiting our flexibility in planning for, or reacting to, changes in our
     business and the industry in which we compete.

   In January 2002, we entered into an interest rate swap with respect to
$300.0 million of our 4.75% Convertible Subordinated Notes. The January
interest rate swap is designated as an effective hedge of the fair value of our
$300.0 million of 4.75% Convertible Subordinated Notes (the "Notes"). The
objective of the swap is to convert the 4.75% fixed interest rate on the Notes
to a variable interest rate based on the 6-month London Interbank Offered Rate
("the LIBOR rate") plus 86 basis points. The gain or loss from changes in the
fair value of the swap is expected to entirely offset the loss or gain from
changes in the fair value of the Notes throughout the life of the Notes. The
swap creates a market exposure to changes in the LIBOR rate. If the LIBOR rate
increases or decreases by 1%, our interest expense would increase or decrease
by $750,000 quarterly on a pretax basis. If the LIBOR rate does not change from
the rate of 1.84% at the inception of the swap, we would be able to reduce
interest expense from the current amount each quarter by approximately $1.5
million. Under the terms of the swap, we were required to provide initial
collateral in the form of cash or cash equivalents to Goldman Sachs Capital
Markets, L.P. ("GSCM") in the amount of $6.0 million as continuing security for
our obligations under the swap (irrespective of movements in the value of the
swap) and from time to time additional collateral can change hands between
Mercury and GSCM as swap rates and equity prices fluctuate. We will account for
the initial collateral and any additional collateral as restricted cash on our
balance sheet. As of March 12, 2002, we were required to provide additional
collateral of $6.0 million therefore our total restricted cash as of such date
was $12.0 million.

   In February 2002, we entered into a second interest rate swap with GSCM that
does not qualify for hedge accounting treatment under SFAS 133 and therefore is
marked-to-market through other income each quarter. The life of this swap is
through July 1, 2007, the same date as the first swap and the original maturity
date of the Notes. The swap entitles us to receive approximately $608,000 from
GSCM semi-annually during the life of the swap, subject to the following
conditions:

  .  If the price of our common stock exceeds the original conversion or
     redemption price of the Notes, we will be required to pay the fixed rate
     of 4.75% and receive a variable rate on the $300.0 million principal
     amount of the Notes. We would no longer receive the $608,000 payment
     semi-annually.

  .  If we call the Notes at a premium (in whole or in part), or if any of the
     holders of the Notes elect to convert the Notes (in whole or in part), we
     will be required to pay a variable rate and receive the fixed rate of
     4.75% on the principal amount of such called or converted Notes. However,
     we would continue to receive the $608,000 from GSCM semi-annually provided
     that the price of our common stock during the life of the swap never
     exceeds the original conversion or redemption price of the Notes.

   We are exposed to credit exposure with respect to GSCM as counterparty under
both swaps. However, we believe that the risk of such credit exposure is
limited because GSCM is an affiliate of a major U.S. investment bank and
because its obligations under both swaps are guaranteed by the Goldman Sachs
Group L.P.

                                      34

<PAGE>

Item 7a.  Quantitative and Qualitative Disclosures about Market Risk

   Our exposure to market rate risk includes risk for changes in interest to
our investment portfolio. We place our investments with high quality issuers
and, by policy, limit the amount of credit exposure to any one issuer or issue.
In addition, we have classified all of our investments as "held to maturity."
Information about our investment portfolio is presented in the table below,
which states notional amounts and related weighted-average interest rates by
year of maturity (in thousands):

<TABLE>
<CAPTION>
                                           December 31,
                                        ------------------
                                          2002      2003    Thereafter  Total    Fair Value
                                        --------  --------  ---------- --------  ----------
<S>                                     <C>       <C>       <C>        <C>       <C>
Cash equivalents
   Fixed rate.......................... $204,160        --        --   $204,160   $204,487
   Weighted average rate...............     2.57%       --                 2.57%
Investments
   Fixed rate.......................... $169,484  $115,198   $55,893   $340,575   $346,567
   Weighted average rate...............     5.23%     4.87%     5.07%      4.87%
Total investments...................... $373,644  $115,198   $55,893    544,735   $551,054
Weighted average rate..................     3.78%     4.87%     5.07%      4.14%
</TABLE>

   Our long-term investments include $55.0 million of government agency
instruments, which have callable provisions and accordingly may be redeemed by
the agencies should interest rates fall below the coupon rate of the
investments.

   The fair value of our convertible subordinated debentures fluctuates based
upon changes in the price of our common stock, changes in interest rates and
changes in our creditworthiness. The fair market value of the convertible
subordinated debentures as of December 31, 2001 was $304.7 million while the
book value was $377.5 million.

   In January 2002, we entered into an interest rate swap with respect to
$300.0 million of our 4.75% Convertible Subordinated Notes. The January
interest rate swap is designated as an effective hedge of the fair value of our
$300.0 million of 4.75% Convertible Subordinated Notes (the "Notes"). The
objective of the swap is to convert the 4.75% fixed interest rate on the Notes
to a variable interest rate based on the 6-month London Interbank Offered Rate
("the LIBOR rate") plus 86 basis points. The gain or loss from changes in the
fair value of the swap is expected to entirely offset the loss or gain from
changes in the fair value of the Notes throughout the life of the Notes. The
swap creates a market exposure to changes in the LIBOR rate. If the LIBOR rate
increases or decreases by 1%, our interest expense would increase or decrease
by $750,000 quarterly on a pretax basis. If the LIBOR rate does not change from
the rate of 1.84% at the inception of the swap, we would be able to reduce
interest expense from the current amount each quarter by approximately $1.5
million. Under the terms of the swap, we were required to provide initial
collateral in the form of cash or cash equivalents to Goldman Sachs Capital
Markets, L.P. ("GSCM") in the amount of $6.0 million as continuing security for
our obligations under the swap (irrespective of movements in the value of the
swap) and from time to time additional collateral can change hands between
Mercury and GSCM as swap rates and equity prices fluctuate. We will account for
the initial collateral and any additional collateral as restricted cash on our
balance sheet. As of March 12, 2002, we were required to provide additional
collateral of $6.0 million therefore our total restricted cash as of such date
was $12.0 million.

   In February 2002, we entered into a second interest rate swap with GSCM that
does not qualify for hedge accounting treatment under SFAS 133 and therefore is
marked-to-market through other income each quarter. The life of this swap is
through July 1, 2007, the same date as the first swap and the original maturity
date of the Notes. The swap entitles us to receive approximately $608,000 from
GSCM semi-annually during the life of the swap, subject to the following
conditions:

  .  If the price of our common stock exceeds the original conversion or
     redemption price of the Notes, we will be required to pay the fixed rate
     of 4.75% and receive a variable rate on the $300.0 million principal
     amount of the Notes. We would no longer receive the $608,000 payment
     semi-annually.

                                      35

<PAGE>

  .  If we call the Notes at a premium (in whole or in part), or if any of the
     holders of the Notes elect to convert the Notes (in whole or in part), we
     will be required to pay a variable rate and receive the fixed rate of
     4.75% on the principal amount of such called or converted Notes. However,
     we would continue to receive the $608,000 from GSCM semi-annually provided
     that the price of our common stock during the life of the swap never
     exceeds the original conversion or redemption price of the Notes.

   We are exposed to credit exposure with respect to GSCM as counterparty under
both swaps. However, we believe that the risk of such credit exposure is
limited because GSCM is an affiliate of a major U.S. investment bank and
because its obligations under both swaps are guaranteed by the Goldman Sachs
Group L.P.

   We have entered into forward foreign exchange contracts ("forward
contracts") to hedge foreign currency denominated receivables due from certain
European and Asia Pacific subsidiaries and foreign branches against
fluctuations in exchange rates. We have not entered into forward contracts for
speculative or trading purposes. Our accounting policies for these contracts
are based on our designation of the contracts as hedging transactions. The
criteria we use for designating a forward contract as a hedge considers its
effectiveness in reducing risk by matching hedging instruments to underlying
transactions. Gains and losses on forward contracts are recognized in other
income in the same period as gains and losses on the underlying transactions.
The effect of an immediate 10% change in exchange rates would not have a
material impact on our operating results or cash flows.

   A portion of our business is conducted in currencies other than the US
dollar. Our operating expenses in each of these countries are in the local
currencies, which mitigates a significant portion of the exposure related to
local currency revenues.

   From time to time, we make investments in private companies and venture
capital funds. As of December 31, 2001, we had invested $18.9 million in
private companies. In addition, we have committed to make capital contributions
to a venture capital fund totaling $12.0 million and we expect to pay
approximately $9.0 million through March 31, 2003 as capital calls are made. If
the companies in which we have made investments do not complete initial public
offerings or are not acquired by publicly traded companies or for cash, we may
not be able to sell these investments. In addition, even if we are able to sell
these investments we cannot assure that we will be able to sell them at a gain
or even recover our investment. The recent general decline in the Nasdaq
National Market and the market prices of publicly traded technology companies,
as well as any additional declines in the future, will adversely affect our
ability to realize gains or a return of our capital on many of these
investments.

Item 8.  Financial Statements and Supplementary Data

   Financial statements required pursuant to this Item are presented beginning
on page F-1 of this report.

Item 9.  Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

   During the 24-month period preceding December 31, 2001 we neither changed
accountants nor had disagreements with our accountants on any matter of
accounting principles or practices, financial statement disclosure or auditing
scope and procedures.

                                      36

<PAGE>

                                   PART III

   Certain information required by Part III is omitted from this Annual Report
on Form 10-K because we will file a definitive proxy statement within 120 days
after the end of our fiscal year pursuant to Regulation 14A for our annual
meeting of stockholders, currently scheduled for May 15, 2002, and the
information included in the proxy statement is incorporated herein by reference.

Item 10.  Directors and Executive Officers of the Registrant

   The information concerning our officers required by this Item is
incorporated by reference to the section of Part I of this Annual Report on
Form 10-K entitled "Item 1. Business--Personnel." The information concerning
our directors required by this Item is incorporated by reference to the
information under the heading "Election of Directors--Nominees" in our proxy
statement.

Item 11.  Executive Compensation

   The information required by this Item is incorporated by reference to our
proxy statement under the heading "Executive Compensation."

Item 12.  Security Ownership of Certain Beneficial Owners and Management

   The information required by this Item is incorporated by reference to our
proxy statement under the heading "Security Ownership of Certain Beneficial
Owners and Management."

Item 13.  Certain Relationships and Related Transactions

   The information required by this Item is incorporated by reference to our
proxy statement under the heading "Certain Transactions."

                                      37

<PAGE>

                                    PART IV

Item 14.  Exhibits, Financial Statement Schedules and Reports on Form 8-K

   (a) The following documents are filed as a part of this report:

      1. Financial Statements.

   The following financial statements of Mercury Interactive Corporation are
filed as a part of this report:

<TABLE>
<CAPTION>
                                                                           Page
                                                                           ----
<S>                                                                        <C>
Report of Independent Accountants......................................... F-1
Consolidated Balance Sheets at December 31, 2001 and 2000................. F-2
Consolidated Statements of Operations for the years ended December 31,
  2001, 2000 and 1999..................................................... F-3
Consolidated Statements of Stockholders' Equity for the years ended
  December 31, 2001, 2000 and 1999........................................ F-4
Consolidated Statements of Cash Flows for the years ended December 31,
  2001, 2000 and 1999..................................................... F-5
Notes to Consolidated Financial Statements................................ F-6
</TABLE>

      2.  Schedules

   Financial statement schedules not listed above have been omitted because
they are not applicable or the required information is shown in the financial
statements or notes thereto.

      3. Exhibits

<TABLE>
<CAPTION>
  Exhibit
  Number                                              Description
-----------                                           -----------
<C>         <S>
3.1(1)      Certificate of Incorporation of Mercury Interactive, as amended and restated to date.

3.2(12)     Certificate of Amendment of the Restated Certificate of Incorporation.

3.3(3)      By-laws of Mercury Interactive, as amended to date.

10.1(4),(2) Amended and Restated 1989 Stock Option Plan and forms of Incentive Stock Option Agreement
            and Nonstatutory Stock Option Agreement.

10.2(1)     Form of Directors' and Officers' Indemnification Agreement.

10.3(4),(2) Form of 1998 Employee Stock Purchase Plan and form of Agreements.

10.4(1)     401(k) Plan.

10.5(5),(2) 1994 Directors' Stock Option Plan and form of Agreements.

10.6(6),(2) Form of Change of Control Agreements entered into by Mercury Interactive with the Chairman,
            the Chief Executive Officer, the Executive Vice President and the Chief Financial Officer, Chief
            Operating Officer and the President of European Operations.

10.7(7),(2) Amended and Restated 2000 Supplemental Stock Option Plan.

10.8(7),(2) Amended and Restated 1999 Stock Option Plan.

10.9(9)     Preferred Share Purchase Rights Agreement.

10.10(10)   Amendment to Rights Agreement dated March 31,1999.

10.11(11)   Amendment No. Two to Rights Agreement, dated May 19, 2000.

10.12(12)   Purchase and Sale Agreement by and between WHSUM Real Estate Limited Partnership and
            Mercury Interactive.

10.13(8)    Form of Note for Mercury Interactive 4.75% Convertible Subordinated Notes due July 1, 2007.

10.14(8)    Indenture between Mercury Interactive, as Issuer and Chase Manhattan Bank and Trust
            Company, National Association, as Trustee dated July 3, 2000 related to Mercury Interactive
            4.75% Convertible Subordinated Notes due July 1, 2007.
</TABLE>

                                      38

<PAGE>

<TABLE>
<CAPTION>
  Exhibit
  Number                                             Description
------------                                         -----------
<C>          <S>
10.15(8)     Registration Rights Agreement among Mercury Interactive and Goldman, Sachs & Chase
             Securities Inc. and Deutsche Banc Securities Inc. dated June 27, 2000 related to the Mercury
             Interactive 4.75% Convertible Subordinated Notes due July 1, 2007.

10.16(2)(12) Amended and Restated Employment Agreement by and between Mercury Interactive and
             Douglas P. Smith effective as of August 28, 2000.

10.17(13)    Agreement and Plan of Merger among Freshwater Software, Inc., Mercury Interactive
             Corporation and Aqua Merger Company dated as of May 1, 2001.

10.18        Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated
             January 17, 2002 (as revised on January 31, 2002), and Confirmation regarding Swap
             Transaction from Goldman Sachs Capital Markets, L.P. dated February 26, 2002.

21.1         Subsidiaries of Mercury Interactive.

23.1         Consent of Independent Accountants.

24.1         Power of Attorney (see page 40).
</TABLE>
--------
 (1) Exhibits 3.1, 3.3, 10.2, and 10.4 are incorporated by reference to
     Exhibits 3.3, 3.4, 10.2, and 10.12, respectively, filed in response to
     Item 16(a), "Exhibits," of Mercury Interactive Registration Statement on
     Form S-1, as amended (File No. 33-68554), which was declared effective on
     October 29, 1993.
 (2) Designates management contract or compensatory plan arrangements required
     to be filed as an exhibit of this Annual Report on Form 10-K.
 (3) Exhibit 3.3 is incorporated by reference to Exhibit 3.2 filed with the
     Form 10-Q for the three month period ended June 30, 1999
 (4) Exhibits 10.1 and 10.3 are incorporated by reference to Exhibits 4.1 and
     4.3 filed with the Registration Statement on Form S-8, No. 333-62125,
     filed with the Securities and Exchange Commission on August 24, 1998.
 (5) Exhibit 10.5 is incorporated by reference to Exhibit 10.1 filed with the
     Form 10-Q for the quarter ended September 30, 1994.
 (6) Exhibit 10.6 is incorporated by reference to Exhibit 10.26 filed with the
     Form 10-K for the year ended December 31, 1998.
 (7) Exhibits 10.7 and 10.8 are incorporated by reference to Exhibits 4.1 and
     4.2 filed with the Registration Statement on Form S-8, No. 333-56316,
     filed with the Securities and Exchange Commission on February 28, 2001.
 (8) Exhibits 10.13, 10.14 and 10.15 are incorporated by reference to Exhibits
     4.1, 4.2 and 4.3, respectively, filed with the Form 10-Q for the quarter
     ended June 30, 2000.
 (9) Exhibit 10.9 is incorporated by reference to Exhibit 1 to Form 8-A, filed
     with the Securities and Exchange Commission on July 9, 1996.
(10) Exhibit 10.10 is incorporated by reference to Exhibit 1 to Form 8-A,
     Amendment No. 1, filed with the Securities and Exchange Commission on
     April 2, 1999.
(11) Exhibit 10.11 is incorporated by reference to Exhibit 1 to Form 8-A,
     Amendment No. 2, filed with the Securities and Exchange Commission on May
     22, 2000.
(12) Exhibits 3.2, 10.12 and 10.16 are incorporated by reference to Exhibit
     3.2, 10.12 and 10.16, respectively, filed with the Form 10-K for the year
     ended December 31, 2000.
(13) Exhibit 10.17 is incorporated by reference to Exhibit 10.1 filed with the
     Form 10-Q for the quarter ended June 30, 2001.

   (b) Reports on Form 8-K

   No report on Form 8-K was filed during the fourth quarter of the year ended
December 31, 2001.

                                      39

<PAGE>

                                  SIGNATURES

   Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant, Mercury Interactive Corporation, a
corporation organized and existing under the laws of the State of Delaware, has
duly caused this Report to be signed on its behalf by the undersigned,
thereunto duly authorized.

Dated: March 25, 2002

                                               MERCURY INTERACTIVE CORPORATION

                                               By:     /S/  DOUGLAS P. SMITH
                                                   -----------------------------
                                                         Douglas P. Smith,
                                                   Executive Vice President and
                                                      Chief Financial Officer

   KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints jointly and severally, Amnon Landan, Susan J.
Skaer and/or Douglas P. Smith and each one of them, his or her
attorneys-in-fact, each with the power of substitution, for him or her in any
and all capacities, to sign any and all amendments to this Annual Report on
Form 10-K and to file the same, with exhibits thereto and other documents in
connection therewith, with the Securities and Exchange Commission, hereby
ratifying and confirming all that each of said attorneys-in-fact, or his or her
substitute or substitutes, may do or cause to be done by virtue hereof.

          Signature                       Title                  Date
          ---------                       -----                  ----

      /S/  AMNON LANDAN       President and Chief Executive March 25, 2002
-----------------------------   Officer (Principal
        Amnon Landan            Executive Officer) and
                                Chairman of the Board of
                                Directors

    /S/  DOUGLAS P. SMITH     Executive Vice President and  March 25, 2002
-----------------------------   Chief Finance Officer
      Douglas P. Smith          (Principal Financial
                                Officer)

    /S/  DAVID A. KEMPSKI     Vice President, Finance       March 25, 2002
-----------------------------   (Principal Accounting
      David A. Kempski          Officer)

      /S/  IGAL KOHAVI        Director                      March 25, 2002
-----------------------------
         Igal Kohavi

      /S/  YAIR SHAMIR        Director                      March 25, 2002
-----------------------------
         Yair Shamir

      /S/  GIORA YARON        Director                      March 25, 2002
-----------------------------
         Giora Yaron

     /S/  KENNETH KLEIN       Director                      March 25, 2002
-----------------------------
        Kenneth Klein

                                      40

<PAGE>

                       REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of
Mercury Interactive Corporation

   In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)(1) present fairly, in all material respects, the
financial position of Mercury Interactive Corporation and its subsidiaries (the
"Company") at December 31, 2001 and 2000, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2001, in conformity with accounting principles generally accepted in the
United States of America. These financial statements are the responsibility of
the Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally accepted in the
United States of America, which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion.

PRICEWATERHOUSECOOPERS LLP

San Jose, California
January 22, 2002, except for Note 12,
  which is as of March 12, 2002

                                      F-1

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

                          CONSOLIDATED BALANCE SHEETS
                   (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                                                      December 31,
                                                                                   ------------------
                                                                                     2001      2000
                                                                                   --------  --------
                                     ASSETS
<S>                                                                                <C>       <C>
Current assets:
   Cash and cash equivalents...................................................... $248,297  $226,387
   Short-term investments.........................................................  179,484   402,356
   Trade accounts receivable, net of sales reserves of $6,180 and
     $8,229, respectively.........................................................   66,529    62,989
   Prepaid expenses and other assets..............................................   30,945    34,549
                                                                                   --------  --------
       Total current assets.......................................................  525,255   726,281
Long-term investments.............................................................  161,091   153,623
Property and equipment, net.......................................................   93,375    82,895
Investments in non-consolidated companies.........................................   18,944        --
Debt issuance costs, net..........................................................    8,828    13,576
Goodwill and other intangible assets, net.........................................  117,843        --
Other assets......................................................................    2,289        --
                                                                                   --------  --------
       Total assets............................................................... $927,625  $976,375
                                                                                   ========  ========
                      LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
   Accounts payable............................................................... $ 12,420  $ 12,931
   Accrued liabilities............................................................   58,131    58,942
   Income taxes payable...........................................................   32,630    23,797
   Deferred revenue...............................................................   92,619    77,673
                                                                                   --------  --------
       Total current liabilities..................................................  195,800   173,343
Convertible subordinated notes....................................................  377,480   500,000
                                                                                   --------  --------
       Total liabilities..........................................................  573,280   673,343
                                                                                   --------  --------
Commitments and contingencies (Note 6)
Stockholders' equity:
   Common stock: par value $.002 per share, 240,000 shares authorized; 82,849 and
     81,129 shares issued and outstanding, respectively...........................      166       162
   Capital in excess of par value.................................................  232,750   190,232
   Treasury stock.................................................................  (16,082)       --
   Notes receivable from issuance of stock........................................  (11,164)   (7,528)
   Unearned stock-based compensation..............................................   (4,795)       --
   Accumulated other comprehensive loss...........................................   (2,265)   (1,415)
   Retained earnings..............................................................  155,735   121,581
                                                                                   --------  --------
       Total stockholders' equity.................................................  354,345   303,032
                                                                                   --------  --------
       Total liabilities and stockholders' equity................................. $927,625  $976,375
                                                                                   ========  ========
</TABLE>

  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-2

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                   (in thousands, except per share amounts)

<TABLE>
<CAPTION>
                                                                        Year ended December 31,
                                                                       --------------------------
                                                                         2001     2000     1999
                                                                       -------- -------- --------
<S>                                                                    <C>      <C>      <C>
Revenue:
   License............................................................ $236,600 $216,100 $130,900
   Service............................................................  124,400   90,900   56,800
                                                                       -------- -------- --------
       Total revenue..................................................  361,000  307,000  187,700
                                                                       -------- -------- --------
Cost of revenue:
   License............................................................   24,158   17,138    7,736
   Service............................................................   29,231   24,679   16,957
                                                                       -------- -------- --------
       Total cost of revenue..........................................   53,389   41,817   24,693
                                                                       -------- -------- --------
Gross profit..........................................................  307,611  265,183  163,007
                                                                       -------- -------- --------
Operating expenses:...................................................
   Research and development (excluding stock-based compensation of
     $550, $0, $0, respectively)......................................   37,162   32,042   23,484
   Marketing and selling (excluding stock-based compensation of $998,
     $0, $0, respectively)............................................  189,600  151,897   89,874
   General and administrative (excluding stock-based compensation of
     $451, $0, $0, respectively)......................................   23,086   17,831   11,662
   Amortization of unearned stock-based compensation..................    1,999       --       --
   Restructuring, integration and other related charges...............    5,361       --    2,000
   Amortization of goodwill and other intangible assets...............   30,125       --       --
                                                                       -------- -------- --------
       Total operating expenses.......................................  287,333  201,770  127,020
                                                                       -------- -------- --------
Income from operations................................................   20,278   63,413   35,987
Other income, net.....................................................   10,068   17,462    6,026
                                                                       -------- -------- --------
Income before provision for income taxes..............................   30,346   80,875   42,013
Provision for income taxes............................................   12,504   16,175    8,869
                                                                       -------- -------- --------
Net income before extraordinary item..................................   17,842   64,700   33,144
Extraordinary item--gain on early retirement of debt, net of taxes....   16,312       --       --
                                                                       -------- -------- --------
Net income............................................................ $ 34,154 $ 64,700 $ 33,144
                                                                       ======== ======== ========
Basic net income per share:
   Net income before extraordinary item............................... $   0.21 $   0.81 $   0.44
   Extraordinary item--gain on early retirement of debt, net of taxes.     0.20       --       --
                                                                       -------- -------- --------
   Net income......................................................... $   0.41 $   0.81 $   0.44
                                                                       ======== ======== ========
Diluted net income per share:
   Net income before extraordinary item............................... $   0.20 $   0.70 $   0.39
   Extraordinary item--gain on early retirement of debt, net of taxes.     0.18       --       --
                                                                       -------- -------- --------
   Net income......................................................... $   0.38 $   0.70 $   0.39
                                                                       ======== ======== ========
Weighted average common shares (basic)................................   82,559   79,927   76,112
                                                                       ======== ======== ========
Weighted average common shares and equivalents (diluted)..............   89,725   91,938   85,208
                                                                       ======== ======== ========
</TABLE>

  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-3

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                (in thousands)

<TABLE>
<CAPTION>
                                                                     Capital              Notes                  Accumulated
                                                      Common stock  in excess           receivable   Unearned       other
                                                     -------------   of par   Treasury     from    stock-based  comprehensive
                                                     Shares  Amount   value    stock     issuance  compensation     loss
                                                     ------  ------ --------- --------   of stock  ------------ -------------
<S>                                                  <C>     <C>    <C>       <C>       <C>        <C>          <C>
Balance at December 31, 1998........................ 73,990   $148  $128,428  $     --   $ (5,130)   $     --      $  (775)
Collection of notes receivable......................     --     --        --        --        387          --           --
Stock issued under stock option and employee stock
 purchase plans.....................................  4,100      8    20,398        --       (347)         --           --
Currency translation adjustments....................     --     --        --        --         --          --         (467)
Net income..........................................     --     --        --        --         --          --           --
                                                     ------   ----  --------  --------   --------    --------      -------
Balance at December 31, 1999........................ 78,090    156   148,826        --     (5,090)         --       (1,242)

Tax benefit from stock options......................     --     --    12,805        --         --          --           --
Collection of notes receivable......................     --     --        --        --      2,314          --           --
Stock issued under stock option and employee stock
 purchase plans.....................................  3,039      6    28,601        --     (4,752)         --           --
Currency translation adjustments....................     --     --        --        --         --          --         (173)
Net income..........................................     --     --        --        --         --          --           --
                                                     ------   ----  --------  --------   --------    --------      -------
Balance at December 31, 2000........................ 81,129    162   190,232        --     (7,528)         --       (1,415)

Repurchase of common stock..........................   (784)    (1)       --   (16,082)        --          --           --
Unearned stock-based compensation...................     --     --    10,777        --         --     (10,436)          --
Amortization of unearned stock-based compensation...     --     --        --        --         --       1,659           --
Reversal of unearned stock-based compensation.......     --     --    (3,982)       --         --       3,982           --
Tax benefit from stock options......................     --     --     6,118        --                     --           --
Vested stock options assumed in conjunction with the
 Freshwater acquisition.............................     --     --       850        --         --          --           --
Collection of notes receivable......................     --     --        --        --        400          --           --
Stock issued under stock option and employee stock
 purchase plans.....................................  2,504      5    28,755        --     (4,036)         --           --
Currency translation adjustments....................     --     --        --        --         --          --         (850)
Net income..........................................     --     --        --        --         --          --           --
                                                     ------   ----  --------  --------   --------    --------      -------
Balance at December 31, 2001........................ 82,849   $166  $232,750  $(16,082)  $(11,164)   $ (4,795)     $(2,265)
                                                     ======   ====  ========  ========   ========    ========      =======
</TABLE>
<TABLE>
<CAPTION>


                                                     Retained Stockholders' Comprehensive
                                                     earnings    equity     income (loss)
                                                     -------- ------------- -------------
<S>                                                  <C>      <C>           <C>
Balance at December 31, 1998........................ $ 23,737   $146,408
Collection of notes receivable......................       --        387
Stock issued under stock option and employee stock
 purchase plans.....................................       --     20,059
Currency translation adjustments....................       --       (467)      $  (467)
Net income..........................................   33,144     33,144        33,144
                                                     --------   --------       -------
Balance at December 31, 1999........................   56,881    199,531       $32,677
                                                                               =======
Tax benefit from stock options......................       --     12,805
Collection of notes receivable......................       --      2,314
Stock issued under stock option and employee stock
 purchase plans.....................................       --     23,855
Currency translation adjustments....................       --       (173)      $  (173)
Net income..........................................   64,700     64,700        64,700
                                                     --------   --------       -------
Balance at December 31, 2000........................  121,581    303,032       $64,527
                                                                               =======
Repurchase of common stock..........................       --    (16,083)
Unearned stock-based compensation...................       --        341
Amortization of unearned stock-based compensation...       --      1,659
Reversal of unearned stock-based compensation.......       --         --
Tax benefit from stock options......................       --      6,118
Vested stock options assumed in conjunction with the
 Freshwater acquisition.............................       --        850
Collection of notes receivable......................       --        400
Stock issued under stock option and employee stock
 purchase plans.....................................       --     24,724
Currency translation adjustments....................       --       (850)         (850)
Net income..........................................   34,154     34,154        34,154
                                                     --------   --------       -------
Balance at December 31, 2001........................ $155,735   $354,345       $33,304
                                                     ========   ========       =======
</TABLE>

  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-4

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                (in thousands)

<TABLE>
<CAPTION>
                                                                          Year ended December 31,
                                                                      -------------------------------
                                                                         2001       2000       1999
                                                                      ----------  ---------  --------
<S>                                                                   <C>         <C>        <C>
Cash flows from operating activities:
   Net income........................................................ $   34,154  $  64,700  $ 33,144
   Adjustments to reconcile net income to net cash provided by
     operating activities:
   Depreciation and amortization.....................................     14,977      9,624     6,063
   Sales return reserve..............................................     (2,034)     2,696     1,910
   Amortization of goodwill and other intangible assets..............     30,124         --        --
   Amortization of stock-based compensation..........................      1,999         --        --
   Gain on early retirement of debt..................................    (19,833)        --        --
   Non-cash restructuring charges....................................        230         --        --
   Deferred income taxes, net........................................      1,744     (2,340)   (2,802)
   Changes in assets and liabilities:
       Trade accounts receivable.....................................       (614)   (26,537)  (14,259)
       Prepaid expenses and other assets.............................       (556)    (9,031)   (3,705)
       Accounts payable..............................................       (750)     4,702     4,076
       Accrued liabilities...........................................     (1,731)    25,873    16,164
       Income taxes payable..........................................     13,359     17,459     8,688
       Deferred revenue..............................................     11,993     42,634    11,718
                                                                      ----------  ---------  --------
          Net cash provided by operating activities..................     83,062    129,780    60,997
                                                                      ----------  ---------  --------
Cash flows from investing activities:
   Maturity of investments, net......................................  1,082,720    275,860    28,616
   Purchases of investments..........................................   (867,315)  (758,333)  (68,325)
   Purchases of investments in non-consolidated companies............    (18,944)        --        --
   Cash paid in conjunction with Freshwater, net.....................   (143,961)        --        --
   Acquisition of property and equipment, net........................    (22,091)   (45,231)  (23,776)
                                                                      ----------  ---------  --------
          Net cash provided by (used in) investing activities........     30,409   (527,704)  (63,485)
                                                                      ----------  ---------  --------
Cash flows from financing activities:
   Proceeds from issuance of convertible subordinated notes, net.....         --    485,380        --
   Proceeds from issuance of common stock, net.......................     25,124     26,169    20,446
   Repurchase of treasury stock......................................    (16,083)        --        --
   Retirement of convertible subordinated notes......................   (100,024)        --        --
                                                                      ----------  ---------  --------
          Net cash provided by (used in) financing activities........    (90,983)   511,549    20,446
                                                                      ----------  ---------  --------
Effect of exchange rate changes on cash..............................       (578)      (584)   (1,448)
                                                                      ----------  ---------  --------
Net increase in cash.................................................     21,910    113,041    16,510
Cash and cash equivalents at beginning of year.......................    226,387    113,346    96,836
                                                                      ----------  ---------  --------
Cash and cash equivalents at end of year............................. $  248,297  $ 226,387  $113,346
                                                                      ==========  =========  ========
</TABLE>

  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-5

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1--THE COMPANY AND ITS SIGNIFICANT ACCOUNTING POLICIES

   Mercury Interactive Corporation (the "Company") was incorporated in 1989 and
began shipping testing products in 1991. Since 1991, the Company has introduced
a variety of solutions for enterprise testing, production tuning and
application performance management which are focused on helping its customers
deploy better quality applications and to ensure their performance and
availability post-deployment. The Company also provides both professional
services to help customers implement its solutions as well as managed services
for customers who do not want or have the internal resources to implement its
solutions.

   The Company acquired all of the outstanding securities of Freshwater
Software, Inc. in May 2001. The transaction was accounted for as a purchase,
and accordingly, the operating results of Freshwater have been included in
consolidated financial statements since the date of acquisition (See Note 11).

   The Company acquired Conduct Ltd. on November 30, 1999, which was accounted
for as a pooling of interests. The consolidated financial statements for the
year ended December 31, 1999 and the accompanying notes reflect the results of
operations as if the acquired entity was a wholly-owned subsidiary since its
inception (see Note 11).

  Basis of presentation

   The Company has a wholly-owned research and development and sales subsidiary
incorporated in Israel and sales subsidiaries in Asia, Australia, Brazil,
Canada, Europe, and South Africa for marketing, distribution and support of
products and services. The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiaries. All significant
intercompany accounts and transactions have been eliminated.

  Use of estimates

   The preparation of financial statements in conformity with accounting
principles generally accepted in the US requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.

  Foreign currency translation

   In preparing the Company's consolidated financial statements, the Company is
required to translate the financial statements of the foreign subsidiaries from
the currency in which they keep their accounting records, generally the local
currency, into US dollars, the reporting currency. This process results in
exchange gains and losses which, under the relevant accounting guidance are
either included within the statement of operations or as a separate part of our
net equity under the caption cumulative translation adjustment. If any
subsidiary's functional currency is deemed to be the local currency, then any
gain or loss associated with the translation of that subsidiary's financial
statements is included in cumulative translation adjustments. However, if the
functional currency is deemed to be the US dollar then any gain or loss
associated with the translation of these financial statements would be included
within our statements of operations.

   The functional currency of the Company's subsidiary in Israel is the US
dollar. Assets and liabilities in Israel are translated at year-end exchange
rates, except for property and equipment, which is translated at historical
rates. Revenues and expenses are translated at average exchange rates in effect
during the year, except for costs related to those balance sheet items, which
are translated at historical rates. Foreign currency translation gains and
losses are included in the consolidated statements of operations.

                                      F-6

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The functional currencies of all other subsidiaries are the local
currencies. Accordingly, all assets and liabilities of these subsidiaries are
translated at the current exchange rate at the end of the period and revenues
and expenses at average exchange rates in effect during the period. The gains
and losses from translation of these subsidiaries' financial statements are
recorded as other accumulated comprehensive income and included as a separate
component of stockholders' equity. Net gains and losses resulting from foreign
exchange transactions were not significant during any of the periods presented.

  Derivative financial instruments

   The Company adopted Statement of Financial Accounting Standard (SFAS) No.
133, Accounting for Derivative Instruments and Hedging Activities, as amended,
on January 1, 2001. The standard requires the Company to recognize all
derivatives on the balance sheet at fair value. Derivatives that are not hedges
must be adjusted to fair value through the statement of operations. If the
derivative is a hedge, depending on the nature of the hedge, changes in the
fair value of derivatives will either be offset against the change in fair
value of the hedged assets, liabilities or firm commitments through earnings,
or recognized in other comprehensive income (loss) until the hedged item is
recognized in earnings. The ineffective portion of a derivative's change in
fair value will be immediately recognized in earnings. The accounting for gains
or losses from changes in fair value of a derivative instrument depends on
whether it has been designated and qualifies as part of a hedging relationship,
as well as on the type of hedging relationship. The adoption of SFAS No. 133
did not have a material effect on the financial statements of the Company.

   The Company enters into forward foreign exchange contracts ("forward
contracts") to hedge foreign currency denominated intercompany receivables
against fluctuations in exchange rates. The Company does not enter into forward
contracts for speculative or trading purposes. The criteria used for
designating a forward contract as a hedge considers its effectiveness in
reducing risk by matching hedging instruments to underlying transactions. Gains
and losses on forward contracts are recognized in other income in the same
period as gains and losses on the underlying transactions. The Company had
outstanding forward contracts with notional amounts totaling $15.4 million,
$13.0 million and $10.6 million at December 31, 2001, 2000 and 1999,
respectively. The open forward contracts at December 31, 2001 mature at various
dates through August 2002 and are hedges of certain foreign currency
transaction exposures in the Australian dollar, Danish Kroner, Euro, Norwegian
Kroner, Japanese Yen, Swiss Franc and Swedish Kroner. The unrealized net gain
on the Company's forward contracts at December 31, 2001 and 2000 was $606,000
and $282,000, respectively.

  Cash and cash equivalents

   The Company considers all highly liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents.

  Short-term and long-term investments

   The Company considers all investments with remaining maturities of less than
one year to be short-term investments and all investments with remaining
maturities greater than one year to be long-term investments. In accordance
with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," the Company has categorized its marketable securities as "held to
maturity" securities.

   The investments, which all have contractual maturities of less than three
years, are carried at cost plus accrued interest. Realized gains or losses are
determined based on the specific identification method and are reflected in
other income.

                                      F-7

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The portfolio of short-term and long-term investments (including cash and
cash equivalents) consisted of the following (in thousands):

<TABLE>
<CAPTION>
                                                     December 31,
                                                   -----------------
           Investment Type                           2001     2000
           ---------------                         -------- --------
           <S>                                     <C>      <C>
           Cash and interest bearing demand
             deposits............................. $122,374 $ 50,126
           Corporate debt securities..............  313,208  462,108
           Municipal securities...................   42,583  112,973
           US treasury and agency securities......  110,707  157,159
                                                   -------- --------
              Total............................... $588,872 $782,366
                                                   ======== ========
</TABLE>

   During the fourth quarter of 2001, in conjunction with the retirement of a
portion of the convertible subordinated notes, the Company sold $118.0 million
of amortized held-to-maturity investments which resulted in realized gains of
$362,000. The sale of held-to-maturity investments was done to retire the
convertible subordinated debt and, accordingly was an isolated event not
anticipated to recur. The Company continues to have the intent and ability to
hold investments to maturity.

  Concentration of credit risks

   Financial instruments, which potentially subject the Company to
concentrations of credit risk, consist principally of cash, cash equivalents,
investments and accounts receivable. The Company invests primarily in
marketable securities and places its investments with high quality financial,
government or corporate institutions. Accounts receivables are derived from
sales to customers located primarily in the US and Europe. The Company performs
ongoing credit evaluations of its customers and to date has not experienced any
material losses. At and for the years ended December 31, 2001, 2000 and 1999,
no customer accounted for more than 10% of accounts receivable or revenue.

  Fair value of financial instruments

   The carrying amount of the Company's financial instruments, including cash,
cash equivalents, investments, accounts receivable and accounts payable
approximates their respective fair values due to the short maturities of these
financial instruments. Changes in the fair value of the Company's foreign
currency forward contracts ("forward contracts") are generally offset by
changes in the value of the underlying exposures being hedged.

   The fair value of the Company's convertible subordinated debentures was
$304.7 million and $522.6 million at December 31, 2001 and 2000, respectively,
based on quoted market price.

  Property and equipment

   Property and equipment are stated at cost. Depreciation and amortization are
provided using the straight-line method over the estimated economic lives of
assets, which are five to seven years for office furniture and equipment, two
to five years for computers and related equipment, four to ten years for
leasehold improvements, or the term of the lease, whichever is shorter, and
thirty years for buildings.

  Internal use software

   The Company recognizes software development costs in accordance with the
Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer
Software Developed of Obtained for Internal Use."

                                      F-8

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Software development costs, including costs incurred to purchase third party
software, are capitalized beginning when the Company has determined certain
factors are present, including among others, that technology exists to achieve
the performance requirements, buy versus internal development decisions have
been made and the Company's management has authorized the funding for the
project. Capitalization of software costs ceases when the software is
substantially complete and is ready for its intended use and is amortized over
its estimated useful life of generally three years using the straight-line
method. At December 31, 2001 and 2000, the Company had capitalized software of
$8.2 million and $5.1 million, respectively. For the years ended December 31,
2001, 2000 and 1999, the Company incurred amortization expense of $2.0 million,
$1.3 million and $568,000, respectively.

   When events or circumstances indicate the carrying value of internal use
software might not be recoverable, the Company will assess the recoverability
of these assets by determining whether the amortization of the asset balance
over its remaining life can be recovered through undiscounted future operating
cash flows. The amount of impairment, if any, is recognized to the extent that
the carrying value exceeds the projected discounted future operating cash flows
and is recognized as a write down of the asset. In addition, when it is no
longer probable that computer software being developed will be placed in
service, the asset will be recorded at the lower of its carrying value or fair
value, if any, less direct selling costs.

  Investments in non-consolidated companies

   The Company makes venture capital investments in early stage private
companies and private equity funds for business and strategic purposes. These
investments are accounted for under the cost method, as the Company does not
have the ability to exercise significant influence over these companies'
operations. The Company monitors its investments for impairment and will record
reductions in carrying values if and when necessary. This policy includes, but
is not limited to, reviewing each of the companies' cash position, financing
needs, earnings/revenue outlook, operational performance, management/ownership
changes, and competition. The evaluation process is based on information that
the Company requests from these privately-held companies. This information is
not subject to the same disclosure regulations as US public companies, and as
such, the basis for these evaluations is subject to the timing and the accuracy
of the data received from these companies. If the Company believes that the
carrying value of a company is carried at an amount in excess of fair value, it
is our policy to record a reserve and the related writedown is recorded as an
investment loss on our consolidated statements of income. Estimating the fair
value of non-marketable equity investments in early-stage technology companies
is inherently subjective and may contribute to significant volatility in our
reported results of operations.

  Intangible assets

   Intangible assets, including goodwill, purchased technology and other
intangible assets, are carried at cost less accumulated amortization. The
Company amortizes goodwill and other identifiable intangibles on a
straight-line basis over their estimated useful lives. The range of estimated
useful lives on the Company's identifiable intangibles is three to seven years.

  Impairment of intangibles and long-lived assets

   The Company assesses the impairment of identifiable intangibles, goodwill
and fixed assets whenever events or changes in circumstances indicate that the
carrying value may not be recoverable. Factors considered important which could
trigger an impairment review include, but are not limited to, significant
underperformance relative to expected historical or projected future operating
results, significant changes in the manner of use of the acquired assets or the
strategy for the Company's overall business, significant negative industry or
economic trends, significant decline in the Company s stock price for a
sustained period, and the Company's market capitalization relative to net book
value. When the Company determines that the carrying value of long-lived assets
may not be recoverable based upon the existence of one or more of the above
indicators of impairment, the

                                      F-9

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Company measures any impairment based on a projected discounted cash flow
method using a discount rate commensurate with the risk inherent in the
Company's current business model.

  Income taxes

   The Company accounts for income taxes in accordance with the liability
method of accounting for income taxes. Under the liability method, deferred
assets and liabilities are recognized based upon anticipated future tax
consequences attributable to differences between financial statement carrying
amounts of assets and liabilities and their respective tax bases. The provision
for income taxes is comprised of the current tax liability and the change in
deferred tax assets and liabilities. The Company has not recorded a valuation
allowance as of December 31, 2001, because we believe it is more likely than
not that all deferred tax assets will be realized in the foreseeable future.

  Treasury stock

   The Company accounts for treasury stock under the cost method. Under the
cost method a gain or loss will be determined when treasury stock is reissued
or retired. To date, the Company has not reissued or retired its treasury stock.

  Stock-based compensation

   The Company accounts for stock-based compensation for its employees using
the intrinsic value method presented in Accounting Principles Board ("APB")
Opinion No. 25, "Accounting for Stock Issued to Employees", and related
interpretations, and complies with the disclosure provisions of SFAS No. 123,
"Accounting for Stock-Based Compensation." Under APB 25, compensation expense
is based on the difference, as of the date of the grant, between the fair value
of the Company's stock and the exercise price. The Company accounts for stock
issued to non-employees in accordance with the provisions of SFAS No. 123 and
Emerging Issues Task Force ("EITF") No. 96-18, "Accounting for Equity
Instruments That Are Issued to Other Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services." The Company has not issued stock
options to non-employees except non-employee directors.

   The Company amortizes stock-based compensation using the straight-line
approach over the remaining vesting periods of the related options, which is
generally four years.

  Comprehensive income

   The Company complies with the SFAS No. 130, "Reporting Comprehensive
Income." SFAS 130 requires that all items recognized under accounting standards
as components of comprehensive earnings be reported in an annual financial
statement that is displayed with the same prominence as other annual financial
statements. Comprehensive income has been included in the Consolidated
Statements of Stockholders' Equity for all periods presented.

  Revenue recognition

   The Company derives its revenue from primarily two sources (i) product
revenue, which consists of software license fees and hosted software
arrangements and (ii) services and support revenue which includes software
license maintenance, training, and consulting. The Company licenses its
software products on a term basis or on a perpetual basis. The Company's hosted
software arrangements require customers to pay a fixed fee and receive service
over a period of time, generally one or two years. Customers do not pay any set
up fee. The

                                     F-10

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

Company applies the provisions of Statement of Position (SOP) 97-2, Software
Revenue Recognition, as amended by Statement of Position 98-9 Modification of
SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions to
all transactions involving the sale of software products. In addition, the
Company applies the provisions of Emerging Issues Task Force Issue No. 00-03
Application of AICPA Statement of Position 97-2 to Arrangements that Include
the Right to Use Software Stored on Another Entity's Hardware to our hosted
software transactions.

   The Company recognizes revenue from the sale of software licenses when
persuasive evidence of an arrangement exists, the product has been delivered,
the fee is fixed and determinable and collection of the resulting receivable is
probable. Delivery generally occurs when product is delivered to a common
carrier. At the time of the transaction, the Company assesses whether the fee
associated with our revenue transactions is fixed and determinable and whether
or not collection is probable. The Company assesses whether the fee is fixed
and determinable based on the payment terms associated with the transaction. If
a significant portion of a fee is due after our normal payment terms, which are
30 to 60 days from invoice date, the Company accounts for the fee as not being
fixed and determinable. In these cases, the Company recognizes revenue as the
fees become due. The Company assesses collection based on a number of factors,
including past transaction history with the customer and the credit-worthiness
of the customer. The Company does not request collateral from our customers. If
the Company determines that collection of a fee is not probable, the Company
defers the fee and recognize revenue at the time collection becomes probable,
which is generally upon receipt of cash. For all sales, except those completed
over the Internet, the Company uses either a customer order document or signed
license or service agreement as evidence of an arrangement. For sales over the
Internet, the Company uses a credit card authorization as evidence of an
arrangement.

   For arrangements with multiple obligations (for example, undelivered
maintenance and support), the Company allocates revenue to each component of
the arrangement using the residual value method based on the fair value of the
undelivered elements, which is specific to the Company. This means that the
Company defers revenue from the arrangement fee equivalent to the fair value of
the undelivered elements. Fair values for the ongoing maintenance and support
obligations for our licenses are based upon separate sales of renewals to other
customers or upon renewal rates quoted in the contracts. Fair value of
services, such as training or consulting, are based upon separate sales by us
of these services to other customers. Most of the Company's arrangements
involve multiple obligations. The Company's arrangements do not generally
include acceptance clauses. However, if an arrangement includes an acceptance
provision, acceptance occurs upon the earlier of receipt of a written customer
acceptance or expiration of the acceptance period. The Company recognize
revenue for maintenance services ratably over the contract term. Training and
consulting services are billed based on hourly rates, and the Company generally
recognize revenue as these services are performed.

   In accordance with the provisions of Accounting Principles Board Opinion No.
29, "Accounting for Nonmonetary Transactions" ("APB 29"), the Company records
barter transactions at the fair value of the goods or services provided or
received, whichever is more readily determinable in the circumstances. To date,
revenues from barter transactions have been insignificant and represent less
than 1% of net revenues.

  Research and development

   The Company accounts for research and development costs in accordance with
SFAS No. 86, "Accounting for Costs of Computer Software to be Sold, Leases or
Otherwise Marketed." Costs incurred in the research and development of new
software products are expensed as incurred until technological feasibility is
established. Development costs are capitalized beginning when a product's
technological feasibility has been established and ending when the product is
available for general release to customers. Technological feasibility is
reached when the product reaches the working model stage. To date, products and
enhancements have generally reached

                                     F-11

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

technological feasibility and have been released for sale at substantially the
same time and all research and development costs have been expensed.
Consequently, no research and development costs have been capitalized in 2001,
2000 or 1999.

  Net income per share

   Earnings per share is calculated in accordance with the provisions of SFAS
No. 128, "Earnings per Share". SFAS No. 128 requires the reporting of both
basic earnings per share, which is the weighted-average number of common shares
outstanding, and diluted earnings per share, which includes the
weighted-average number of common shares outstanding and all dilutive potential
common shares outstanding, using the treasury stock method. For the three years
ended December 31, 2001, 2000 and 1999, dilutive potential common shares
outstanding reflects shares issuable under the Company's stock option plans.

   The following table summarizes the Company's earnings per share computations
for the three years ended December 31, 2001, 2000 and 1999 (in thousands,
except per share amounts):

<TABLE>
<CAPTION>
                                                                         Year ended December 31,
                                                                         -----------------------
                                                                          2001    2000    1999
                                                                         ------- ------- -------
<S>                                                                      <C>     <C>     <C>
Numerator:
   Net income before extraordinary item................................. $17,842 $64,700 $33,144
   Extraordinary item--gain on early retirement of debt, net of taxes...  16,312      --      --
                                                                         ------- ------- -------
   Net income........................................................... $34,154 $64,700 $33,144
                                                                         ======= ======= =======
Denominator:
   Denominator for basic net income per share--weighted
     average shares.....................................................  82,559  79,927  76,112
   Incremental common shares attributable to shares issuable under
     employee stock plans...............................................   7,166  12,011   9,096
                                                                         ------- ------- -------
   Denominator for diluted net income per share--weighted
     average shares.....................................................  89,725  91,938  85,208
                                                                         ======= ======= =======
   Basic net income per share:
       Net income before extraordinary item............................. $  0.21 $  0.81 $  0.44
       Extraordinary item--gain on early retirement of debt,
         net of taxes...................................................    0.20      --      --
                                                                         ------- ------- -------
       Net income....................................................... $  0.41 $  0.81 $  0.44
                                                                         ======= ======= =======
   Diluted net income per share:
       Net income before extraordinary item............................. $  0.20 $  0.70 $  0.39
       Extraordinary item--gain on early retirement of debt, net of
         taxes..........................................................    0.18      --      --
                                                                         ------- ------- -------
       Net income....................................................... $  0.38 $  0.70 $  0.39
                                                                         ======= ======= =======
</TABLE>

   For the year ended December 31, 2001, options to purchase 5,990,000 shares
of common stock with a weighted average price of $67.44 were considered
anti-dilutive because the options' exercise price was greater than the average
fair market value of the Company's common stock for the period then ended. For
the year ended December 31, 2000, options to purchase 314,000 shares of common
stock with a weighted average price of $107.37 were considered anti-dilutive.
For the year ended December 31, 1999, options to purchase

                                     F-12

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

504,000 shares common stock with a weighted average price of $38.50 were
considered anti-dilutive. For the year ended December 31, 2001 and 2000, common
stock reserved for issuance upon conversion of the outstanding convertible
subordinated notes for 3,393,000 and 4,494,000 shares, respectively, were not
included in diluted earnings per share because the conversion would be
anti-dilutive.

  Segment reporting

   The Company complies with the SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information." SFAS 131 establishes standards for the
manner in which public companies report information about operating segments in
annual and interim financial statements. During each of the three years ended
December 31, 2001, 2000 and 1999, the Company's chief decision makers
considered its business activities to be focused on the license of its products
and related services to end user customers. Since management's primary form of
internal reporting is aligned with the offering of products and services, the
Company believes it operates in one segment. Information related to geographic
segments is included in Note 10.

  Recent accounting pronouncements

   In May 2000, the EITF issued EITF Issue No. 00-14, Accounting for Certain
Sales Incentives. EITF Issue No. 00-14 addresses the recognition, measurement,
and income statement classification for sales incentives that a vendor
voluntarily offers to customers (without charge), which the customer can use
in, or exercise as a result of, a single exchange transaction. Sales incentives
that fall within the scope of EITF Issue No. 00-14 include offers that a
customer can use to receive a reduction in the price of a product or service at
the point of sale. The EITF changed the transition date for Issue 00-14,
concluding that a company should apply this consensus no later than the
company's annual or interim financial statements for the periods beginning
after December 15, 2001.

   In June 2001, the EITF issued EITF Issue No. 00-25, Vendor Income Statement
Characterization of Consideration Paid to a Reseller of the Vendor's Products,
effective for periods beginning after December 15, 2001. EITF Issue No. 00-25
addresses whether consideration from a vendor to a reseller is (a) an
adjustment of the selling prices of the vendor's products and, therefore,
should be deducted from revenue when recognized in the vendor's statement of
operations or (b) a cost incurred by the vendor for assets or services received
from the reseller and, therefore, should be included as a cost or expense when
recognized in the vendor's statement of operations. Upon application of these
EITFs, financial statements for prior periods presented for comparative
purposes should be reclassified to comply with the income statement display
requirements under these Issues.

   In September of 2001, the EITF issued EITF Issue No. 01-09, Accounting for
Consideration Given by Vendor to a Customer or a Reseller of the Vendor's
Products, which is a codification of EITF Issues No. 00-14, No. 00-25 and No.
00-22, Accounting for Points and Certain Other Time-or Volume-Based Sales
Incentive Offers and Offers for Free Products or Services to be Delivered in
the Future. The adoption of SFAS No. 141 did not have a significant impact on
the Company's financial statements.

   In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 141, Business Combinations. SFAS No. 141 requires the purchase method of
accounting for business combinations initiated after June 30, 2001 and
eliminates the pooling-of-interests method. The Company believes that the
adoption of SFAS No. 141 will not have a significant impact on its financial
statements.

   In 2002, SFAS No. 142, Goodwill and Other Intangible Assets became effective
and as a result, the Company has ceased to amortize approximately $109.5
million of goodwill and $1.7 million of workforce and has reclassified the
workforce to goodwill. The Company has recorded approximately $28.4 million of

                                     F-13

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

amortization on these amounts during 2001 and would have recorded approximately
$46.5 million of amortization during 2002. In lieu of amortization, the Company
is required to perform a preliminary assessment of goodwill in 2002 and an
annual impairment review thereafter and potentially more frequently if
circumstances change. The Company completed the preliminary assessment during
the first quarter of 2002 and did not record an impairment charge. The Company
also ceased to amortize the deferred tax asset associated with the workforce of
approximately $661,000. The Company had recorded approximately $169,000 of
amortization during 2001 and would have recorded approximately $277,000 during
2002. In lieu of amortization, the Company is required to offset the deferred
tax asset against the deferred tax liability. The Company expects to amortize
approximately $2.6 million of purchased technology during the year ending
December 31, 2002.

   The impairment review involves a two-step process as follows:

  .  Step 1--the Company will compare the fair value of its reporting units to
     the carrying value, including goodwill of each of those units. For each
     reporting unit where the carrying value, including goodwill, exceeds the
     unit's fair value, the Company will move on to step 2. If a unit's fair
     value exceeds the carrying value, no further work is performed and no
     impairment charge is necessary.

  .  Step 2--the Company will perform an allocation of the fair value of the
     reporting unit to its identifiable tangible and non-goodwill intangible
     assets and liabilities. This will derive an implied fair value for the
     reporting unit's goodwill. The Company will then compare the implied fair
     value of the reporting unit's goodwill with the carrying amount of the
     reporting unit's goodwill. If the carrying amount of the reporting unit's
     goodwill is greater than the implied fair value of its goodwill, an
     impairment loss must be recognized for the excess.

   In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. SFAS No. 144 addresses significant issues
relating to the implementation of SFAS No. 121, Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and develops
a single accounting method under which long-lived assets that are to be
disposed of by sale are measured at the lower of book value or fair value less
cost to sell. Additionally, SFAS No. 144 expands the scope of discontinued
operations to include all components of an entity with operations that (1) can
be distinguished from the rest of the entity and (2) will be eliminated from
the ongoing operations of the entity in a disposal transaction. SFAS No. 144 is
effective for financial statements issued for fiscal years beginning after
December 15, 2001 and its provisions are to be applied prospectively. The
adoption of SFAS No. 144 did not have an impact on the Company's financial
position and results of operations.

                                     F-14

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 2--FINANCIAL STATEMENT COMPONENTS

<TABLE>
<CAPTION>
                                                           December 31,
                                                        ------------------
                                                          2001      2000
                                                        --------  --------
                                                          (in thousands)
    <S>                                                 <C>       <C>
    Property and equipment, net:
       Land and buildings.............................. $ 51,994  $ 44,189
       Computers and equipment.........................   46,835    35,961
       Office furniture and equipment..................   10,524     8,422
       Leasehold improvements..........................    6,778     4,189
                                                        --------  --------
                                                         116,131    92,761
       Less: Accumulated depreciation and amortization.  (42,753)  (29,337)
                                                        --------  --------
                                                          73,378    63,424
       Construction in progress........................   19,997    19,471
                                                        --------  --------
                                                        $ 93,375  $ 82,895
                                                        ========  ========
</TABLE>

   Depreciation and amortization expense of property and equipment for the
three years ended December 31, 2001, 2000 and 1999 was $13.4 million, $8.7
million, and $5.4 million, respectively. For the years ended December 31, 2001,
2000, and 1999 there were no capital leases.

<TABLE>
<CAPTION>
                                                                            December 31,
                                                                          -----------------
                                                                            2001     2000
                                                                          --------  -------
                                                                           (in thousands)
<S>                                                                       <C>       <C>
Goodwill and other intangible assets, net:
   Goodwill.............................................................. $137,365  $    --
   Purchased workforce...................................................    2,100       --
   Purchased technology..................................................    5,500       --
   Deferred tax asset associated with purchased workforce and technology.    3,002       --
                                                                          --------  -------
                                                                           147,967       --
   Less: Accumulated amortization........................................  (30,124)      --
                                                                          --------  -------
                                                                          $117,843  $    --
                                                                          ========  =======
Accrued liabilities:
   Payroll related and sales commissions................................. $ 26,006  $26,784
   Vacation and severance................................................   10,213    7,241
   Interest on convertible subordinated notes............................    8,965   11,743
   Other.................................................................   12,947   13,174
                                                                          --------  -------
                                                                          $ 58,131  $58,942
                                                                          ========  =======
</TABLE>

                                     F-15

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


<TABLE>
<CAPTION>
                                                Year ended December 31,
                                              ---------------------------
                                                2001      2000     1999
                                              --------  --------  -------
                                                     (in thousands)
      <S>                                     <C>       <C>       <C>
      Other income, net:
         Interest income..................... $ 36,424  $ 30,526  $ 6,480
         Interest expense....................  (23,559)  (11,775)      --
         Debt-issuance cost amortization.....   (2,085)   (1,044)      --
         Foreign exchange losses and other...     (712)     (245)    (454)
                                              --------  --------  -------
                                              $ 10,068  $ 17,462  $ 6,026
                                              ========  ========  =======
      Sales reserve:
         Balance at beginning of period...... $  8,229  $  5,533  $ 3,623
         Additions...........................    9,329    12,959    4,485
         Deductions..........................  (11,378)  (10,263)  (2,575)
                                              --------  --------  -------
                                              $  6,180  $  8,229  $ 5,533
                                              ========  ========  =======
</TABLE>

NOTE 3--SUPPLEMENTAL CASH FLOW DISCLOSURES

   Supplemental cash flow disclosures for the year ended December 31, 2001,
2000 and 1999 are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                     Year ended December 31,
                                                                     -----------------------
                                                                       2001    2000    1999
                                                                     -------  ------- ------
                                                                         (in thousands)
<S>                                                                  <C>      <C>     <C>
Supplemental disclosure:
   Cash paid during the year for income taxes....................... $ 1,605  $ 2,008 $1,354
                                                                     =======  ======= ======
   Cash paid during the year for interest expense................... $23,618  $    -- $   --
                                                                     =======  ======= ======
Supplemental non-cash investing activities:
   Net assets assumed in conjunction with Freshwater acquisition.... $ 2,383  $    -- $   --
                                                                     =======  ======= ======
   Tax effect of workforce and purchased technology associated with
     Freshwater acquisition......................................... $ 3,002  $    -- $   --
                                                                     =======  ======= ======
   Issuance of common stock for vested options of Freshwater........ $   850  $    -- $   --
                                                                     =======  ======= ======
Supplemental non-cash financing activities:
   Tax benefit from exercise of stock options....................... $ 6,118  $12,805 $   --
                                                                     =======  ======= ======
   Issuance of common stock for notes receivable.................... $ 4,036  $ 4,752 $  347
                                                                     =======  ======= ======
   Elimination of debt offering costs in conjunction with debt
     retirement..................................................... $ 2,663  $    -- $   --
                                                                     =======  ======= ======
</TABLE>

                                     F-16

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 4--RELATED PARTIES

Notes receivable from issuance of stock

   At December 31, 2001 and 2000, the Company held full-recourse notes
receivable collateralized by stock from stockholders of the Company totaling
$3.7 million and $7.5 million, respectively, for purchases of the Company's
common stock. The notes bear interest at the market rate on the date of
issuance specific to the employee. Accrued interest is due quarterly. The
principal amount is due five years from the anniversary of the notes.

Employee Receivables

   At December 31, 2001 and 2000, the Company held full-recourse notes
receivable collateralized by personal and/or real property with employees of
the Company totaling $2.2 million and $1.1 million, respectively. The notes
bear interest at the market rate on the date of issuance specific to the
employee. The principal and accrued interest are due five years from the
anniversary of the notes.

NOTE 5--LONG-TERM DEBT

   In July 2000, the Company issued $500.0 million in convertible subordinated
notes. The notes mature on July 1, 2007 and bear interest at a rate of 4.75%
per annum, payable semiannually on January 1 and July 1 of each year. The notes
are subordinated in right of payment to all of the Company's future senior
debt. The notes are convertible into shares of the Company's common stock at
any time prior to maturity at a conversion price of approximately $111.25 per
share, subject to adjustment under certain conditions. The Company may redeem
the notes, in whole or in part, at any time on or after July 1, 2003. Accrued
interest to the redemption date will be paid by the Company in each redemption.

   In connection with the issuance of convertible subordinated notes, the
Company incurred $14.6 million of issuance costs, which primarily consisted of
investment banker fees, legal, and other professional fees. During the fourth
quarter of 2001, in conjunction with the retirement of the convertible
subordinated notes the Company wrote-off $2.6 million of debt issuance costs.
The remaining costs are being amortized using a straight-line method over the
remaining term of the notes. Amortization expense related to the issuance costs
was $2.1 million and $1.0 million in 2001 and 2000, respectively. As of
December 31, 2001 and 2000, net debt issuance costs was $8.8 million and $13.5
million, respectively.

   In December 2001, the board of directors authorized a retirement program for
the Company's convertible subordinated notes. Under the retirement program, the
Company may reacquire up to $200.0 million in face value of the notes. In the
fourth quarter of fiscal 2001, the Company paid $102.7 million, including
accrued interest, to retire $122.5 million face value of the notes, which
resulted in an extraordinary gain on the early retirement of debt of $19.8
million plus other related gains of $557,000 primarily related to the gain on
sale of held-to-maturity investments, net of related taxes of $4.1 million. As
of December 31, 2001, the notes had a remaining book value of $368.7 million.

                                     F-17

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 6--COMMITMENTS AND CONTINGENCIES

Lease commitments

   The Company leases facilities for sales offices in the US and foreign
locations under non-cancelable operating leases that expire through 2008.
Certain of these leases contain renewal options. The Company leases certain
equipment under various leases with lease terms ranging from month-to-month up
to one year. Future minimum payments under the facilities and equipment leases
with non-cancelable terms in excess of one year are as follows as of December
31, 2001 (in thousands):

<TABLE>
<CAPTION>
                                        Year Ending
                                        -----------
                             <S>        <C>
                             2002......   $ 7,550
                             2003......     5,800
                             2004......     2,766
                             2005......     1,225
                             2006......       436
                             Thereafter       281
                                          -------
                                Total..   $18,058
                                          =======
</TABLE>

   Total rent expense under operating leases amounted to $6.2 million, $4.1
million and $2.8 million for the years ended December 31, 2001, 2000 and 1999,
respectively.

Contingencies

   From time to time, the Company may have certain contingent liabilities that
arise in the ordinary course of its business activities. The Company accrues
for contingent liabilities when it is probable that future expenditures will be
made and such expenditures can be reasonably estimated. In the opinion of
management, there are no pending claims of which the outcome is expected to
result in a material adverse effect in the financial position or results of
operations of the Company.

NOTE 7--STOCKHOLDERS' EQUITY

1989 Plan

   In August 1989, the Company adopted a stock option plan (the "1989 Plan").
Options granted under the 1989 Plan are for periods not to exceed ten years.
For holders of 10% or more of the total combined voting power of all classes of
the Company's stock, options may not be granted at less than 110% of the fair
value of the common stock at the date of grant and the option term may not
exceed 5 years. Incentive stock option grants under the 1989 Plan must be at
exercise prices not less than 100% of the fair market value and non-statutory
stock option grants under the 1989 Plan must be at exercise prices not less
than 85% of the fair market value of the stock on the date of grant. Options
are immediately exercisable but all shares purchased upon exercise of options
are subject to repurchase by the Company until vested. Options generally vest
over a period of four years. Options are no longer granted under this plan.

1994 Director Plan

   On August 3, 1994, the board of directors adopted the 1994 Directors' Stock
Option Plan (the "Directors' Plan"). The Company reserved 2,000,000 shares of
Common Stock for issuance upon exercise of stock options to be granted during
the ten year term of the Directors' Plan. Only outside directors may be granted
options under

                                     F-18

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

the Directors' Plan. The Plan provided for an initial option grant of 25,000
shares to the Company's outside directors as of August 3, 1994 or upon initial
election to the board of directors after August 3, 1994. In addition, the plan
provided for automatic annual grants of 5,000 shares upon re-election of the
individual to the board of directors. In August 1998, the stockholders agreed
to amend the Directors' Plan to increase the number of shares granted to 50,000
shares as an initial grant to new non-employee directors, 10,000 shares as the
annual grant to continuing non-employee directors of the Company, and to
provide for a one-time grant of 100,000 shares to the non-employee directors of
the Company who were serving as directors of the Company as of August 14, 1998.
The option term is ten years, and options are exercisable while such person
remains a director. The exercise price is not less than 100% of fair market
value on the date of grant. The initial option grants and the one-time grants
vest 20% annually for each director on the date of each Annual Meeting of
Stockholders of the Company after the date of grant of such option. The annual
option grants shall vest in full on the fifth anniversary following each
individual's re-election to the board of directors.

1996 Supplemental Plan

   In May 1996, the Company adopted a stock option plan solely for grants to
employees of its subsidiaries located outside the US (the "Supplemental Plan").
The provisions of the Supplemental Plan regarding option term, grant price,
exercise price, and vesting period is identical to those of the 1989 Plan.
Options are no longer granted under this plan.

1999 Plan

   In August 1998, the stockholders adopted the 1999 Stock Option Plan (the
"1999 Plan") to replace the 1989 Plan, effective on the expiration of the term
of such plan in August 1999. The Company reserved 900,000 shares of common
stock for issuance upon exercise of stock options to be granted under this
plan. The provisions of the 1999 Plan regarding option term, grant price,
exercise price, and vesting period are identical to those of the 1989 Plan
except that all options granted under the 1999 Plan must be at exercise prices
not less than 100% of the fair market value. In December 1999, the stockholders
approved an automatic increase in the aggregate number of shares reserved for
issuance under the 1999 Plan of 4% of the common stock and equivalents
outstanding as of January 1 of each year starting in 2000 and ending in 2003.
In 2002, 2001, and 2000, the 1999 Plan shares reserved were automatically
increased by 3,995,750 shares, 3,879,728 shares and 7,301,500 shares,
respectively.

2000 Plan

   In July 2000, the Company adopted the 2000 Supplemental Stock Option Plan
(the "2000 Plan") which allows for options to be granted to any employee of the
Company who is not a US citizen or resident and who is not an executive officer
or director of the Company. The Company reserved 2,000,000 shares of common
stock for issuance upon exercise of stock options to be granted under the 2000
Plan. In February 2001, the Board approved the reservation of an additional
4,000,000 shares. In November 2000, the Board amended and restated the 2000
Plan to better address tax issues of the Company and its employees in countries
other than the US . The provisions of the 2000 Plan regarding option term,
grant price and exercise price are identical to those of the 1999 Plan except
that all the term of options granted in certain European countries may be
different and the 2000 Plan provides for the grant of stock purchase rights.

1997 Freshwater Plan

   In May 2001, in conjunction with the acquisition of Freshwater Software,
Inc. the Company assumed the 1997 Freshwater Stock Option Plan ("1997
Freshwater Plan"). The provisions of the 1997 Freshwater Plan regarding option
term, grant price, exercise price, and vesting period are identical to those of
the 1999 Plan. Freshwater vested and unvested options were converted to the
Company's shares at a conversation ratio of 0.1326. Options are no longer
granted under this plan.

                                     F-19

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   The following table presents the combined activity of all the Company's
option plans for the years ended December 31, 2001, 2000 and 1999 (shares in
thousands):

<TABLE>
<CAPTION>
                                                       Options outstanding
                                                     ------------------------
                                            Options               Weighted
                                           available Number of    average
                                           for grant  Shares   exercise price
                                           --------- --------- --------------
  <S>                                      <C>       <C>       <C>
  Balance outstanding at December 31, 1998   1,208    12,282       $ 4.63
  Additional shares authorized............   7,857        --           --
  Options granted.........................  (4,931)    4,931        16.02
  Options canceled........................     945      (945)        6.38
  Options exercised.......................      --    (3,752)        4.50
                                            ------    ------
  Balance outstanding at December 31, 1999   5,079    12,516         9.02
  Additional shares authorized............   5,637        --           --
  Options granted.........................  (8,345)    8,345        55.44
  Options canceled........................     256      (652)       25.61
  Options exercised.......................      --    (2,814)        7.78
                                            ------    ------       ------
  Balance outstanding at December 31, 2000   2,627    17,395        30.92
  Additional shares authorized............   7,880        --           --
  Options granted.........................  (5,593)    5,593        40.05
  Options canceled........................     981    (1,069)       45.49
  Options exercised.......................      --    (2,328)        8.68
                                            ------    ------       ------
  Balance outstanding at December 31, 2001   5,895    19,591       $35.32
                                            ======    ======       ======
</TABLE>

   The following table presents weighted average price and remaining
contractual life information about significant option groups outstanding under
the above plans at December 31, 2001 (shares in thousands):

<TABLE>
<CAPTION>
                                 Options outstanding                      Options exercisable
                ----------------------------------------------------- ----------------------------
                                Weighted average
Range of          Number           Remaining         Weighted average   Number    Weighted average
Exercise prices outstanding Contractual life (years)  exercise price  Exercisable  exercise price
--------------- ----------- ------------------------ ---------------- ----------- ----------------
<S>             <C>         <C>                      <C>              <C>         <C>
$ 0.08 -- 12.03    5,836              6.25                $ 7.88         4,332         $ 7.07
$15.50 -- 40.72    7,556              8.60                $32.62         2,131         $35.62
$41.34 -- 65.20    5,727              8.81                $61.71         1,196         $61.67
$67.88 --125.44      472              8.60                $97.83           148         $99.21
                  ------                                                 -----
                  19,591              7.96                $35.32         7,807         $24.98
                  ======                                                 =====
</TABLE>

Employee Stock Purchase Plan

   In August 1998, the stockholders adopted the 1998 Employee Stock Purchase
Plan (the "1998 ESPP") and the reserved 1,300,000 shares for issuance
thereunder. In May 2000, the stockholders approved the reservation of an
additional 500,000 shares of common stock for issuance under the 1998 ESPP.
Under the 1998 ESPP, employees are granted the right to purchase shares of
common stock at a price per share that is the lesser of (i) 85% of the fair
market value of the shares at the participant's entry date into the offering
period, or (ii) 85% of the fair market value of the shares at the end of the
offering period. In August 2001, the board of directors changed the offering
period from six months to two years. During 2001, 2000 and 1999, 176,000,
189,000 and 345,000 shares, respectively, were purchased under the 1998 ESPP at
an average purchase price of $44.33, $86.43 and $21.46, respectively.

                                     F-20

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


Employee Benefit Plan

   The Company has a qualified 401(k) plan available to eligible employees.
Participants may contribute up to 15% of their annual compensation to the plan,
limited to a maximum annual amount set by the Internal Revenue Service. The
Company matches employee contributions dollar for dollar up to a maximum of
$1,000 per year per person. Matching contributions vest according to the number
of years of employee service. The Company contributed $568,000 and $415,000 to
the 401(k) plan during 2001 and 2000, respectively. The Company did not
contribute to the 401(k) plan during 1999.

Stock Repurchase Program

   During the third quarter of 2001, the board of directors authorized the
repurchase of 783,500 shares of the Company's common stock in the open market,
subject to normal trading restrictions, at an average price of $20.40. At
December 31, 2001 the Company had treasury stock at cost of $16.1 million.

Amortization of Unearned Stock-Based Compensation

   During the second quarter of 2001, in connection with the acquisition of
Freshwater Software, Inc., the Company recorded unearned stock-based
compensation totaling $10.4 million associated with approximately 140,000
unvested stock options assumed. The options assumed were valued using the fair
market value of the Company's stock on the date of acquisition, which was
$72.21. The Company reduced unearned stock-based compensation by $4.0 million
due to the termination of certain employees in conjunction with the third
quarter restructuring. The Company also recorded unearned stock-based
compensation of $341,000 in conjunction with the third quarter restructuring.
The options were valued using the fair market value of the Company's stock on
the date of accelerated vesting, which was a weighted average of $32.92.
Amortization of unearned stock-based compensation for the year ended December
31, 2001 was $2.0 million. The Company expects to amortize approximately
$600,000 per quarter through the second half of 2005 which is over the
remaining vesting periods of the related options.

Pro Forma Disclosure

   Pro forma information regarding net income and earnings per share is
required by SFAS No. 123. This information is required to be determined as if
the Company had accounted for its employee stock options and stock purchase
plans under the fair value method of that statement.

   The fair value of options and shares issued pursuant to the option plans and
the ESPPs at the grant date were estimated using the Black-Scholes model with
the following weighted average assumptions:

<TABLE>
<CAPTION>
                                    Option plans          ESPP
          -                       ----------------  ----------------
                                  2001  2000  1999  2001  2000  1999
                                  ----  ----  ----  ----  ----  ----
          <S>                     <C>   <C>   <C>   <C>   <C>   <C>
          Expected life (years).. 4.00  4.00  4.00  0.50  0.50  0.50
          Risk-free interest rate 4.60% 6.26% 5.01% 4.60% 6.49% 5.01%
          Volatility.............   92%   88%   83%   92%   88%   83%
          Dividend yield......... None  None  None  None  None  None
</TABLE>

   The Black-Scholes option pricing model was developed for use in estimating
the fair value of traded options that have no vesting restrictions and are
fully transferable. In addition, option pricing models require the input of
highly subjective assumptions including the expected stock price volatility.
The Company uses projected volatility rates, which are based upon historical
volatility rates trended into future years. Because the Company's

                                     F-21

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

employee stock options have characteristics significantly different from those
of traded options, and because changes in the subjective input assumptions can
materially affect the fair value estimate, in management's opinion, the
existing models do not necessarily provide a reliable single measure of the
fair value of the Company's options. Based upon the above assumptions, the
weighted average fair valuation per share of options granted under the option
plans during the years ended December 31, 2001, 2000 and 1999 was $27.03,
$37.02, and $10.12, respectively.

   Pursuant to the requirements of SFAS No. 123, the following are pro forma
net income (loss) and net income (loss) per share for 2001, 2000, and 1999, as
if the compensation costs for the option plans and the ESPPs had been
determined based on the fair value at the grant date for grants in 2001, 2000,
and 1999, consistent with the provisions of SFAS 123:

<TABLE>
<CAPTION>
                                                  2001     2000   1999
                                                --------  ------ -------
        <S>                                     <C>       <C>    <C>
        Pro forma net income (loss) (in
          thousands)........................... $(89,914) $1,097 $13,895
        Pro forma net income (loss) per share
          (basic)..............................    (1.09)   0.01    0.18
        Pro forma net income (loss) per share
          (diluted)............................    (1.00)   0.01    0.16
</TABLE>

   The effects of applying SFAS No.123 on pro forma disclosures of net income
and earnings per share for the fiscal years ended 2001, 2000 and 1999 are not
likely to be representative of the pro forma effects on net income and earnings
per share in the future years for the following reasons: 1) the number of
future shares to be issued under these plans are not known and 2) the
assumptions used to determine the fair value can vary significantly.

NOTE 8--RESTRUCTURING, INTEGRATION AND OTHER RELATED CHARGES

   During the third quarter of 2001, in connection with management's plan to
reduce costs and improve operating efficiencies, the Company recorded
restructuring and other charges of $4.4 million, consisting of $2.9 million for
employee reductions, $1.1 million for the cancellation of a marketing event,
and $400,000 for professional services and consolidation of facilities.
Employee reductions consisted of a reduction in force of approximately 140
employees, or 8% of the Company's worldwide workforce. Total cash outlays
associated with the restructuring are expected to be $4.2 million. The
remaining $0.2 million of costs consists of non-cash charges for asset
write-offs. During the year ended December 31, 2001, cash paid was $3.4
million. The majority of the remaining cash outlays of $770,000, which include
severance costs and fees associated with the cancellation of a marketing event,
occurred during the first quarter of 2002.

   During the second quarter of 2001, in conjunction with the acquisition of
Freshwater Software, Inc., the Company recorded a charge for certain
nonrecurring restructuring and integration costs of $946,000. The charge
included costs for consolidation of facilities, employee severance, and fixed
asset write-offs. The Company expects the remaining costs of $113,000
associated with the charge to be paid during the first half of 2002.

                                     F-22

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


NOTE 9--INCOME TAXES

   The provision for income taxes consisted of (in thousands):

<TABLE>
<CAPTION>
                                                   Year Ended December 31,
                                                  ------------------------
                                                   2001    2000     1999
                                                  ------- -------  -------
     <S>                                          <C>     <C>      <C>
     Federal:
        Current.................................. $ 5,436 $ 8,388  $ 5,375
        Deferred.................................   1,519  (1,708)  (2,681)
                                                  ------- -------  -------
                                                    6,955   6,680    2,694
                                                  ------- -------  -------
     State:
        Current..................................   2,232   2,362      931
        Deferred.................................     225    (452)    (121)
                                                  ------- -------  -------
                                                    2,457   1,910      810
                                                  ------- -------  -------
     Foreign:
        Current..................................   7,170   7,765    5,365
        Deferred.................................      --    (180)      --
                                                  ------- -------  -------
                                                    7,170   7,585    5,365
                                                  ------- -------  -------
            Total provision for income taxes..... $16,582 $16,175  $ 8,869
                                                  ======= =======  =======
</TABLE>

   Income before provision for income taxes consisted of (in thousands):

<TABLE>
<CAPTION>
                                                Year Ended December 31,
                                                ------------------------
                                                 2001     2000    1999
                                                -------  ------- -------
        <S>                                     <C>      <C>     <C>
        Domestic............................... $(4,310) $22,655 $ 9,357
        Foreign................................  55,046   58,220  32,656
                                                -------  ------- -------
                                                $50,736  $80,875 $42,013
                                                =======  ======= =======
</TABLE>

   The extraordinary gain of $20.4 million related to the early retirement of
debt has been recorded on the income statement net of $4.1 million of income
taxes. This tax expense is the difference between provision for income taxes
included in the statement of operations and the footnote.

   The provision for income taxes differs from the amount obtained by applying
the statutory federal income tax rate to income before taxes as follows (in
thousands):

<TABLE>
<CAPTION>
                                                      December 31,
      -                                       ---------------------------
                                                2001      2000     1999
                                              --------  --------  -------
      <S>                                     <C>       <C>       <C>
      Provision at federal statutory rate.... $ 17,776  $ 28,306  $14,705
      State tax, net of federal tax benefit..    1,689     1,146      527
      Foreign rate differentials.............  (11,149)  (14,173)  (8,234)
      Reversal of valuation allowance........   (1,705)       --       --
      Non-utilized net operating losses and
        credits..............................       --       522    3,625
      Tax-exempt interest....................   (2,012)     (992)    (640)
      Non-deductible goodwill................   10,002        --       --
      Other..................................    1,981     1,366   (1,114)
                                              --------  --------  -------
                                              $ 16,582  $ 16,175  $ 8,869
                                              ========  ========  =======
</TABLE>

                                     F-23

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   US income taxes and foreign withholding taxes were not provided for on a
cumulative total of $166.0 million of undistributed earnings for certain non-US
subsidiaries. The Company intends to invest these earnings indefinitely in
operations outside the US. The components of the deferred tax assets
(liabilities) follow (in thousands):

<TABLE>
<CAPTION>
                                                    December 31,
                                                  ----------------
                                                   2001     2000
                                                  -------  -------
            <S>                                   <C>      <C>
            Deferred Tax Assets:
               Reserves and Accruals............. $ 2,978  $ 5,406
               Depreciation and Amortization.....   2,259    1,576
               Net operating loss carryforwards..      --    1,705
                                                  -------  -------
               Gross Deferred Tax Assets.........   5,237    8,687
               Valuation Allowance...............      --   (1,705)
                                                  -------  -------
                   Total Deferred Tax Assets.....   5,237    6,982
            Deferred Tax Liabilities:
               Intangible assets.................  (2,425)      --
                                                  -------  -------
                   Total......................... $ 2,812  $ 6,982
                                                  =======  =======
</TABLE>

   At December 31, 2001, the Company reversed its valuation allowance
originating from net operating losses of foreign jurisdictions on certain of
its deferred tax assets. The Company reversed the valuation allowance because
it believes it is more likely than not that all deferred tax assets will be
realized in the foreseeable future.

   As of December 31, 2001 and 2000, the Company's US net operating loss
carryforwards for income tax purposes were approximately $134.0 million and
$121.0 million, respectively. If not utilized, the federal net operating loss
carryforwards will expire in various years through 2021, and the state net
operating loss carryforwards will expire in various years through 2011. The net
operating losses are primarily attributable to stock option compensation
deductions. Accordingly, the tax benefit realized upon utilization of the net
operating loss carryforwards will be credited directly to equity.

   The Company's income taxes payable for federal, state, and foreign purposes
have been reduced, and the deferred tax liabilities increased, by the tax
benefits associated with dispositions of employee stock options. The Company
receives an income tax benefit calculated as the difference between the fair
market value of the stock issued at the time of exercise and the option price,
tax effected. These benefits were credited directly to shareholders' equity.

   The earnings from foreign operations in Israel are subject to a lower tax
rate pursuant to "Approved Enterprise" incentives effective through 2012. The
incentives provide for certain tax relief if certain conditions are met. The
Company believes it continued to be in compliance with these conditions at
December 31, 2001.

NOTE 10--GEOGRAPHIC REPORTING

   The Company has three reportable operating segments: the Americas; Europe,
the Middle East and Africa (EMEA); and Asia Pacific (APAC). These segments are
organized, managed and analyzed geographically and operate in one industry
segment: the development, marketing, and selling of integrated performance
management solutions. The Company's chief decision makers evaluate operating
segment performance based primarily on net revenues and certain operating
expenses.

                                     F-24

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)


   Financial information for the Company's operating segments is as follows for
the years ended December 31, 2001, 2000 and 1999 (in thousands):

<TABLE>
<CAPTION>
                                           Year ended December 31,
                                          --------------------------
                                            2001     2000     1999
                                          -------- -------- --------
                                                (in thousands)
            <S>                           <C>      <C>      <C>
            Net revenue to third parties:
               Americas.................. $233,900 $208,200 $123,900
               EMEA......................  104,684   78,421   52,800
               APAC......................   22,416   20,379   11,000
                                          -------- -------- --------
                   Consolidated.......... $361,000 $307,000 $187,700
                                          ======== ======== ========
</TABLE>

<TABLE>
<CAPTION>
                                              December 31,
                                            -----------------
                                              2001     2000
                                            -------- --------
                                             (in thousands)
                   <S>                      <C>      <C>
                   Identifiable assets:
                      Americas............. $712,427 $808,583
                      EMEA.................  204,017  170,881
                      APAC.................   11,181   10,111
                                            -------- --------
                          Consolidated..... $927,625 $976,375
                                            ======== ========
</TABLE>

   International sales represented 35% of our total revenues in 2001, 32% in
2000, and 34% in 1999. The subsidiary located in the United Kingdom accounted
for 12%, 10% and 12% of the consolidated net revenue to unaffiliated customers
for the years ended December 31, 2001, 2000 and 1999, respectively. Operations
located in Israel accounted for 17% and 13% of the consolidated identifiable
assets at December 31, 2001 and 2000, respectively.

NOTE 11--ACQUISITIONS

   In May 2001, the Company acquired all of the outstanding securities of
Freshwater Software, Inc. ("Freshwater"), a provider of eBusiness monitoring
and management solutions. The Company acquired Freshwater for cash
consideration of $146.1 million. The purchase price included $849,000 for the
fair value of approximately 13,000 assumed Freshwater vested stock options, as
well as direct acquisition costs of $529,000. The fair value of options assumed
were estimated using the Black-Scholes model with the following assumptions:
fair value of $74.21; expected life (years) of four; risk-free interest rate of
4.41%; volatility of 92%; and dividend yield of zero percent. The allocation of
the purchase price resulted in an excess of purchase price over net tangible
assets acquired of $148.1 million. This was allocated, based on a third party
valuation, $2.1 million to workforce, $5.5 million to purchased technology and
$140.5 million to goodwill, including $3.0 million of goodwill for deferred tax
assets associated with the workforce and purchased technology. During 2001, the
goodwill and other intangible assets were amortized on a straight-line basis
over 3 years. Amortization expense for the year ended December 31, 2001 was
$30.1 million. We expect to amortize approximately $2.6 million of purchased
technology during the year ending December 31, 2002. See Note 1 "Recent
accounting pronouncement" which discusses the implementation of SFAS No. 142.

   The transaction was accounted for as a purchase and, accordingly, the
operating results of Freshwater have been included in the accompanying
consolidated financial statements of the Company from the date of acquisition.
If the purchase had occurred at the beginning of each period, net revenues
attributable to the Company and Freshwater would have been $367.3 million in
2001, $315.8 million in 2000 and $191.5 million in

                                     F-25

<PAGE>

                        MERCURY INTERACTIVE CORPORATION

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)

1999; net income (loss) would have been $4.4 million in 2001, $21.6 million in
2000 and $(26.9) million in 1999; and earnings (loss) per share would have been
$0.05 in 2001, $0.24 in 2000 and $(0.32) in 1999.

   On November 30, 1999, the Company acquired Conduct Ltd. Under terms of the
agreement, 408,000 shares of the Company's common stock was issued in exchange
for all issued and outstanding convertible preferred and common shares of
Conduct, and assumption of all outstanding Conduct stock options, warrants and
other securities. The transaction was accounted for as a pooling of interests
in the year ended December 31, 1999; therefore, all prior periods presented
have been restated to include Conduct in operations since its inception.

NOTE 12--SUBSEQUENT EVENTS

   In January 2002, the Company entered into an interest rate swap with respect
to $300.0 million of its 4.75% Convertible Subordinated Notes. The January
interest rate swap is designated as an effective hedge of the fair value of the
Company's $300.0 million of 4.75% Convertible Subordinated Notes (the "Notes").
The objective of the swap is to convert the 4.75% fixed interest rate on the
Notes to a variable interest rate based on the 6-month London Interbank Offered
Rate ("the LIBOR rate") plus 86 basis points. The gain or loss from changes in
the fair value of the swap is expected to entirely offset the loss or gain from
changes in the fair value of the Notes throughout the life of the Notes. The
swap creates a market exposure to changes in the LIBOR rate. Under the terms of
the swap, the Company the was required to provide initial collateral in the
form of cash or cash equivalents to Goldman Sachs Capital Markets, L.P.
("GSCM")in the amount of $6.0 million as continuing security for the Company's
obligations under the swap (irrespective of movements in the value of the swap)
and from time to time additional collateral can change hands between Mercury
and GSCM as swap rates and equity prices fluctuate. The Company will account
for the initial collateral and any additional collateral as restricted cash on
the Company's balance sheet. As of March 12, 2002, the Company was required to
provide additional collateral of $6.0 million therefore the Company's total
restricted cash as of such date was $12.0 million.

   In February 2002, the Company entered into a second interest rate swap with
GSCM that does not qualify for hedge accounting treatment under SFAS 133 and
therefore is marked-to-market through other income each quarter. The life of
this swap is through July 1, 2007, the same date as the first swap and the
original maturity date of the Notes. The swap entitles us to receive
approximately $608,000 from GSCM semi-annually during the life of the swap,
subject to the following conditions:

  .  If the price of the Company's common stock exceeds the original conversion
     or redemption price of the Notes, the Company will be required to pay the
     fixed rate of 4.75% and receive a variable rate on the $300.0 million
     principal amount of the Notes. The Company would no longer receive the
     $608,000 payment semi-annually.

  .  If the Company calls the Notes at a premium (in whole or in part), or if
     any of the holders of the Notes elect to convert the Notes (in whole or in
     part), the Company will be required to pay a variable rate and receive the
     fixed rate of 4.75% on the principal amount of such called or converted
     Notes. However, the Company would continue to receive the $608,000 from
     GSCM semi-annually provided that the price of the Company's common stock
     during the life of the swap never exceeds the original conversion or
     redemption price of the Notes.

   The Company is exposed to credit exposure with respect to GSCM as
counterparty under both swaps. However, the Company believes that the risk of
such credit exposure is limited because GSCM is an affiliate of a major U.S.
investment bank and because its obligations under both swaps are guaranteed by
the Goldman Sachs Group L.P.

   Through February 28, 2002, the Company has repurchased an additional $29.8
million in face value of the convertible subordinated notes for $24.9 million
including accrued interest.

                                     F-26

<PAGE>

                      UNAUDITED QUARTERLY FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                   Quarter ended
                                    ---------------------------------------------------------------------------
                                    Dec. 31, Sept. 30, June 30, March 31, Dec. 31, Sept. 30, June 30, March 31,
                                      2001     2001      2001     2001      2000     2000      2000     2000
                                    -------- --------- -------- --------- -------- --------- -------- ---------
                                                     (in thousands, except per share amounts)
<S>                                 <C>      <C>       <C>      <C>       <C>      <C>       <C>      <C>
Total revenue...................... $90,300   $84,000  $96,000   $90,700  $97,500   $79,500  $69,600   $60,400
                                    =======   =======  =======   =======  =======   =======  =======   =======
Net income (loss).................. $15,779   $(7,105) $ 9,331   $16,149  $25,806   $16,676  $12,427   $ 9,791
                                    =======   =======  =======   =======  =======   =======  =======   =======
Basic net income per share......... $  0.19   $ (0.09) $  0.11   $  0.20  $  0.32   $  0.21  $  0.16   $  0.12
                                    =======   =======  =======   =======  =======   =======  =======   =======
Diluted net income per share:
    Diluted net income per share... $  0.18   $ (0.09) $  0.10   $  0.18  $  0.28   $  0.18  $  0.14   $  0.11
                                    =======   =======  =======   =======  =======   =======  =======   =======
    Weighted average common
     shares (basic)................  82,765    83,266   82,809    81,408   80,996    80,263   79,507    78,943
                                    =======   =======  =======   =======  =======   =======  =======   =======
    Weighted average common
     shares (diluted)..............  87,722    83,266   91,222    90,941   92,728    92,533   91,282    91,208
                                    =======   =======  =======   =======  =======   =======  =======   =======
</TABLE>


                                     F-27